| Abstract: |
This paper provides a comprehensive empirical investigation of liquidity and its multidimensional impact on the pricing of Bank Nifty futures and options (F&O) on the National Stock Exchange of India. Employing tick-by-tick order-book and trade data spanning 2015–2024, we construct a composite liquidity index via Principal Component Analysis (PCA) that captures 70.8% of common variation across ten distinct liquidity metrics. We document that liquidity deteriorates exponentially with moneyness distance: bid-ask spreads for 10% out-of-the-money (OTM) options reach 295 basis points—a 555% premium over at-the-money (ATM) levels. Cross-sectional regressions confirm a significant illiquidity premium of 2.85 points for futures, 8.52 points for ATM options, and 15.85 points for OTM options. We document strong liquidity commonality (commonality coefficient β = 0.385–0.725) that intensifies to near-perfect correlation during crises (β = 0.925), creating a 'commonality paradox' in which diversification benefits vanish precisely when most needed. Intraday analysis identifies an optimal execution window (10:00–14:00 IST) reducing transaction costs by 20–35 basis points versus open/close periods. A long-short liquidity factor portfolio generates annualised alpha of 3.25% (t = 2.85), surging to 12.85% during the COVID-19 crisis. Liquidity-adjusted Black-Scholes models reduce pricing errors by 33–35% over the standard model. These findings carry direct implications for execution strategy, risk management, and market design in emerging derivatives markets. |
