Volatility uncertainty, time decay, and option bid-ask spreads in an incomplete market

This paper documents the fact that in options markets, the (percentage) implied volatility bid-ask spread increases at an increasing rate as the option's maturity date approaches. To explain this stylized fact, this paper provides a market microstructure model for the bid-ask spread in options markets. We first construct a static equilibrium model to illustrate the aforementioned phenomenon where risk averse and competitive option market makers quote bid and ask prices to minimize their inventory risk in an incomplete market with both directional and volatility risk.We extend this model to multiperiods and showthat the same phenomenon occurs there aswell. Two newimplications are generated: a volatility level effect and a volatility variance effect. These implications are empirically tested, and the empirical results confirm the model's validity. Finally, we document the importance of detrending the maturity effect by showing that the detrended percentage volatility spread explains future jump intensities better than the original percentage volatility spread.