The shape of option implied volatility: a study based on market net demand pressure
AbstractPurpose–Due to disequilibrium between supply and demand in the option market, the option market-maker is under exposure to certain risks because of their net option positions. This paper aims to pay attention to whether the risk award affects the option price and the shape of implied volatility in the market-maker system. Design/methodology/approach–The paper first eliminates the part of implied volatility explained by underlying asset's stochastic volatility-jump price process, and second sorts out market investors' net demand data from TAIEX Options tick by tick deal data and then finally considers three market maker's risks – unhedgeable risk, capital constrain risk and asymmetric information risk, and how they affect implied volatility's level and slope. Findings–Through the research in the TAIEX Option market, the paper finds that, under unhedgeable risk, net demand pressure has a significant impact on implied volatility. Especially, unhedgeable risk due to underlying asset's stochastic volatility has the best explanation for implied volatility level, and unhedgeable risk due to underlying asset's jump can explain implied volatility slope to some extent. Capital constrain risk and asymmetric information risk have an insignificant impact on implied volatility. Research limitations/implications–The findings in this study suggest that the risk award affects the option price and the shape of implied volatility in the market-maker system and different risks have different effects on the level and slope of option implied volatility. Practical implications–This paper finds the influence factors of the option price in the market-maker system. It's useful for China's financial government and investors to learn the price tendency and regular pattern in the future China option market. Originality/value–This is the first time that a net demand pressure based option pricing model is used, which is derived by Garleanu, Pedersen and Poteshman, to study the TAIEX Options' implied volatility. And the paper improves the methods eliminating the part of implied volatility explained by underlying asset's stochastic volatility-jump price process.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Bibliographic InfoArticle provided by Emerald Group Publishing in its journal China Finance Review International.
Volume (Year): 2 (2012)
Issue (Month): 1 (February)
Contact details of provider:
Web page: http://www.emeraldinsight.com
Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
Find related papers by JEL classification:
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Dennis, Patrick & Mayhew, Stewart, 2002. "Risk-Neutral Skewness: Evidence from Stock Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(03), pages 471-493, September.
- Garleanu, Nicolae Bogdan & Pedersen, Lasse Heje & Poteshman, Allen M, 2005.
"Demand-Based Option Pricing,"
CEPR Discussion Papers
5420, C.E.P.R. Discussion Papers.
- Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
- Merton, Robert C., 1975.
"Option pricing when underlying stock returns are discontinuous,"
787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144.
- Nicolas P. B. Bollen & Robert E. Whaley, 2004. "Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?," Journal of Finance, American Finance Association, vol. 59(2), pages 711-753, 04.
- Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Carole Comerton-Forde & Terrence Hendershott & Charles M. Jones & Pamela C. Moulton & Mark S. Seasholes, 2010. "Time Variation in Liquidity: The Role of Market-Maker Inventories and Revenues," Journal of Finance, American Finance Association, vol. 65(1), pages 295-331, 02.
- Alexander David & Pietro Varonesi, 1999. "Option prices with uncertain fundamentals theory and evidence on the dynamics of implied volatilities," Finance and Economics Discussion Series 1999-47, Board of Governors of the Federal Reserve System (U.S.).
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Louise Lister).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.