Reexamining the Relationship between Financial Market Illiquidity and Option Returns: Evidence from China

This study develops an innovative analytical framework in which the end-user net demands for options alter with the level of illiquidity, thereby extending the relationship between option returns and illiquidity from a linear to a more general nonlinear form. This article infers that U-shaped relationships exist between illiquidity and delta-hedged option returns in the Chinese financial market; more importantly, illiquidity exerts opposite U-shaped effects on delta-hedged returns of call and put options. We empirically test these inferences using Chinese financial data. The results indicate that option and underlying asset illiquidity have positive U-shaped effects on weekly delta-hedged call option returns and inverted U-shaped effects on weekly delta-hedged put option returns. Our findings also reveal that the U-shaped relationships between illiquidity and delta-hedged option returns can be modified by implied volatility.