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The impact of option hedging on the spot market volatility

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  • Anderegg, Benjamin
  • Ulmann, Florian
  • Sornette, Didier

Abstract

We theoretically model and empirically quantify the feedback effect of delta hedging for the spot market volatility of the forex market. We start from an economy with two types of traders, an aggregated option market maker (OMM) and an aggregated option market taker (OMT), whose exposures reflect the total outstanding positions of all option traders in the market. A different hedge ratio of the OMM and OMT leads to a net delta hedge activity, which introduces market friction. We represent this friction by a simple linear permanent impact model. This approach allows us to derive the dependence of the spot market volatility on the gamma exposure of the traders. Our theoretical model shows that the spot market volatility is increased (decreased) by a negative (positive) gamma exposure of the OMM, whereby the amount of the increase depends on the net delta hedge amount executed in the spot market. To empirically test this model, we first reconstruct the aggregated OMM’s gamma exposure by using trade repository data and find that it is negative. The empirical analysis performed over the period from 21st October 2017 to 30th June 2018 using our reconstructed OMM data then strongly supports our theoretical model: The gamma exposure of the OMM turns out to be highly significant for the spot market volatility and, as expected, the spot market volatility is increased with the OMM’s short gamma exposure. Quantitatively, a negative gamma exposure of the OMM of approximately −1000 billion USD (which is around what we observe from our reconstructed OMM data) leads to an absolute increase in volatility of 0.7% in EURUSD and 0.9% in USDJPY.

Suggested Citation

  • Anderegg, Benjamin & Ulmann, Florian & Sornette, Didier, 2022. "The impact of option hedging on the spot market volatility," Journal of International Money and Finance, Elsevier, vol. 124(C).
    • Handle: RePEc:eee:jimfin:v:124:y:2022:i:c:s0261560622000304
    DOI: 10.1016/j.jimonfin.2022.102627
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    References listed on IDEAS

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    More about this item

    Keywords

    DTCC; FX options; Delta hedging; Price impact; Trade repository data; Volatility modeling; frictions; feedback effects; instability;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • C80 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - General

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