Completed Research Projects
DFG Project: The Effects of Market Frictions on Option Prices
The German Research Foundation (DFG) funded our project "The Effects of Market Frictions on Option Prices", in which we cooperate with Prof. Dr. Olaf Korn from the Georg-August-University of Göttingen, from 2016 to 2020.
Classic option-pricing theory assumes that assets are traded on frictionless markets. In reality, however, different market frictions prevail, for example, asset illiquidity and funding restrictions for certain groups of market participants. Such market frictions can be substantial, as it was observed during the global financial crisis of 2008 and 2009, and can have an important impact on option prices. The goal of this project is to understand how market frictions affect option prices and option returns. A major challenge for such an investigation is that the direction of price effects depends on net end-user demand for options. If the demand is positive, i.e., end-users want to buy options, market frictions should lead to higher prices, whereas a negative demand should lead to lower prices. Unfortunately, data on end-user demand, in particular for options on individual stocks, is rarely available. Therefore, an essential idea of the project is to develop and empirically test hypotheses about the relation between market frictions and option prices which don't require any knowledge of end-user demand in a first step. This step exploits the idea that frictions should increase the variation of option prices around an appropriate reference value. If the hypotheses are supported by empirical tests for the US stock options market, we can draw conclusions about end-user demand from the difference between option prices and reference values in a second step. The project's main question about the connection between market frictions and option prices is relevant both from a scientific and socio-political perspective. In face of the controversial debate about derivatives markets a better understanding of the functioning of these markets is very important for policy recommendations concerning the design of corporate risk management strategies as well as the design and regulation of options markets. By looking at different market frictions (illiquidity, incompleteness of markets, funding restrictions) and investigating their relative importance for price formation in different market periods the project makes an important contribution in this respect.
Working papers and publications on this DFG project:
- Hitzemann, S.; Hofmann, M.; Uhrig-Homburg, M.; Wagner, C. (2016), Margin Requirements and Equity Option Returns.
- Kanne, S.; Korn, O.; Uhrig-Homburg, M. (2015), Stock Illiquidity, Option Prices, and Option Returns.
FIRM Project: Asset Pricing, Liquidity, and Option Returns
Our project "Asset Pricing, Liquidity, and Option Returns" was funded by the Frankfurt Institute for Risk Management and Regulation (FIRM).
In risk management processes, liquid derivatives markets play an important role. At the same time, classic option-pricing theory assumes that assets are traded on frictionless markets and liquidity concerns are neglected. For the stock and bond market the interaction between liquidity and asset prices is well understood: A higher illiquidity level leads to higher expected returns. However, investigations of the effects of illiquidity in options markets are scarce. Options markets are special as they, in contrast to stock and bond markets, are in zero-net supply. Market makers absorb end-user selling or buying pressure, and hence, market makers can hold long or short positions in options. Depending on end-user demand the sign of the influence of liquidity on option prices can be positive or negative. We want to contribute to this literature by considering the effect of option liquidity level and risk depending on end-user demand in an uniform and integrated setting. In detail, we want to answer the following three main research questions: First, we want to identify the effects that the choice of (daily and intra-daily) liquidity and otion returns measures have on the asset pricing results. This includes an analysis of liquidity measures that account for the characteristics of options markets. Second, we aim to shed light on how end-user demand affects the direction of liquidity effects on option prices. Finally, we want to disentangle the influence from liquidity level and liquidity risk and determine which channel is more important. Putting everything together, the aim is to identify demand-dependent liquidity effects and to determine the importance of different measures of option liquidity and risk on expected option returns.
Fritz Thyssen Project: Size-Dependent Bond Liquidity Measures and their Asset Pricing Implications
Our project "Size-Dependent Bond Liquidity Measures and their Asset Pricing Implications" was funded by the Fritz Thyssen Foundation from 2016 to 2018.
Due to the enormous importance of bond markets for the financing of states and companies, the functioning of these markets is very important from a social perspective. A decisive criterion here is the liquidity of bonds. It indicates how easily (or at what cost) bonds can be traded between different market participants. The recent financial crisis in particular has shown that a drying up of liquidity can lead to high losses in value. The aim of the project is to develop methods to manage the associated risks.
The first part of the research project therefore focuses on the development of a new approach to measure liquidity that takes into account the specifics of the bond market. A decisive feature - albeit neglected by existing approaches - is the strong dependence of transaction costs on the transaction volume. The use of classical liquidity measures therefore leads to an unresolved conflict of objectives. Either only very few trading transactions of comparable volume are taken into account for the calculation of liquidity measures and thus a large part of the available information is ignored. Alternatively, transactions of different volumes are used, which are ultimately not comparable in terms of their transaction costs. The approach to liquidity measurement developed by the project aims to resolve this trade-off and explicitly take into account a dependence of transaction costs on volume. Based on the newly developed volume-dependent measures, the second part of the project will reassess the dependence of the price of a bond on its liquidity. In the literature, often only individual liquidity measures are used to analyse this correlation. It is therefore to be expected that the application of the new approach to liquidity measurement and the associated coverage of further liquidity components will lead to new insights with regard to this issue which is central to risk management.
Working papers and publications on this Fritz Thyssen project:
- Reichenbacher, M.; Schuster, P. (2019), Size-Adapted Bond Liquidity Measures and Their Asset Pricing Implications.
DFG Project: Modelling and Quantification of Credit Risks with Special Consideration of Default Dependencies
From 2007 to 2009, the German Research Foundation (DFG) funded our project "Modelling and Quantification of Credit Risks with Special Consideration of Default Dependencies".
The adequate consideration of default dependencies is one of the most crucial problems in credit risk management. Such dependencies can arise from common risk factors, learning from defaults or contagions. The aim of the project is the theoretical and empirical analysis of default dependencies. For this purpose we develop a theoretical framework that can in principle produce default dependencies in a realistic magnitude and that is furthermore consistently applicable on a large number of borrowers. Using the advantages of a top-down construction we first specify the economy-wide default intensity. Afterwards we apply the concept of random-thinning to break down the economy-wide default risk to subportfolio or single-name level. The evaluation of the models happens in two ways. Within a simulation study we analyze which dependencies can be achieved in our framework in general. We compare the derived default correlations and their consequences for the valuation of credit derivatives to the most important bottom-up approaches. An empirical verification of the model using market data of correlation sensitive credit derivatives should shed light on the question if this model can be a real-world solution.
Working papers and publications on this DFG project:
- Uhrig-Homburg, M.; Kunisch, M. (2008) Modeling Simultaneous Defaults: A Top Down Approach. The journal of fixed income, 18 (1), 25-36.
- Kunisch, M.; Uhrig-Homburg, M. (2008). A Top-Down Framework for Modelling Default Dependencies.
- Uhrig-Homburg, M.; Kunisch, M. (2008). Modelling and Valuation of Default Dependencies in a Top-Down Framework. Proceedings / Actuarial and Financial Mathematics Conference - Interplay between Finance and Insurance, February 7-8, 2008,Brussels, Belgium. Ed.: M. Vanmaele, 81-94, Universa Press, Wetteren.
- Düllmann, K.; Küll, J.; Kunisch, M. (2010). Estimating asset correlations from stock prices or default rates - which method is superior? Journal of economic dynamics & control, 34 (11), 2341-2357. doi:10.1016/j.jedc.2010.06.003.