Analytically pricing European options in dynamic markets: Incorporating liquidity variations and economic cycles

Abstract

This paper discusses the European option pricing problem in the context of asset prices being influenced by liquidity risks and economic cycles. We employ regime switching for asset volatility, and liquidity risks are captured by market-wide liquidity. We obtain an analytical formulation of European option prices, allowing for fast model calibration using real-market data. By estimating model parameters using real option data, we show that pricing errors can be significantly reduced using our model that considers stochastic liquidity, indicating that our model has real-world applications. Our results can help investors and regulators better understand the market and provide a potentially effective risk management tool.