This study illustrates the impact of both spot and option liquidity levels on option prices. Using implied volatility to measure the option price structure, our empirical results reveal that even after controlling for the systematic risk of Duan and Wei (2009), a clear link remains between option prices and liquidity; with a reduction (increase) in spot (option) liquidity, there is a corresponding increase in the level of the implied volatility curve. The former is consistent with the explanation on hedging costs provided by Cetin, Jarrow, Protter, and Warachka (2006), whereas the latter is consistent with the "illiquidity premium" hypothesis of Amihud and Mendelson (1986a). This study also shows that the slope of the implied volatility curve can be partially explained by option liquidity. large agent, whose trades result in price moves, can replicate the payoff of a derivative security, thereby deriving a nonlinear partial differential equation for the hedging strategy.As opposed to directly inferring the price impact of spot liquidity, Cho and Engle (1999) use transaction data to examine the effects of spot market activity on the percentage bid-ask spreads of S&P 100 index options, proposing a new theory on market microstructure which they refer to as "derivative hedge theory." They argue that if market makers in the derivative markets can hedge their positions using the underlying asset, then the liquidity and spread within the derivative markets will be determined by the liquidity in the spot market, rather than by the activities of the derivative market itself. Thus, they find that option market spreads are positively related to spreads in the underlying market.Frey (2000) and Liu and Yong (2005) also consider the costs involved in the replication (or super-replication) of a European option in the presence of price impact. Liquidity with a stochastic supply curve is modeled by Cetin, Jarrow, and Protter (2004) and Cetin et al. (2006), who obtain the pricing formulae for European call options. Cetin et al. (2006) provide further empirical evidence that spot liquidity cost is a significant component of the option price and that the impact of illiquidity is dependent on the moneyness of the option; that is, the impact is more (less) significant for out-of-the-money (in-themoney) options.Following on from these studies, we examine the liquidity effect on option prices from both the spot and option markets. We use data on 30 component stocks in the Dow Jones Industrial Average (DJIA) index as at December 31, 2004. The spot liquidity measures used in this study fall into the two broad categories of "trade-based" and "order-based" measures. Trade-based measures include "cumulative trading volume" (VOL), "number of trades" (NT), and "average trade size" (ATS). Order-based measures include "absolute order imbalance" (AOI), "average proportional quoted spread" (AQS), and "average proportional effective spread" (AES). The option liquidity measures include "trading volume" based on the overall number of contracts (OVOL)...
