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The purpose of this paper is to examine the effect of illiquidity on the value of currency options. We use a unique dataset that allows us to explore this issue in special circumstances where options are issued by a central bank and are not traded prior to maturity. The value of these options is compared to similar options traded on the exchange. We find that the nontradable options are priced about 21 percent less than the exchange-traded options. This gap cannot be arbitraged away due to transactions costs and the risk that the exchange rate will change during the bidding process.ONE IMPORTANT ASPECT OF RESEARCH on the microstructure of financial markets is the effect of liquidity on financial assets. The early microstructure literature views liquidity as a determinant of transactions costs, affecting the bid-ask spreads but not equilibrium prices. 1 More recent studies that deal with the effect of liquidity on the prices of financial assets present evidence that illiquidity has an adverse effect on asset values~e.g., Amihud and Mendelson~1991! on bond prices, Silber~1991! on restricted stocks, and Longstaff~1995! on liquidity, volatility, and price!. 2 These papers deal with the effect of liquidity on stocks and bonds. How about options? Does illiquidity of an option affect its price? Thus far, to our knowledge, this issue has not been discussed in the microstructure literature. 3 for their helpful comments and suggestions. Special thanks to Ken Garbade for spending many hours reading and commenting on every draft of this paper. Many thanks to the Bank of Israel and the Tel-Aviv Stock Exchange for providing the data and responding to our innumerable questions. Finally, we thank René Stulz and the referee of this paper for their many helpful comments and suggestions.

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