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Demand-Based Option Pricing

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  • Nicolae Garleanu
  • Lasse Heje Pedersen
  • Allen M. Poteshman

Abstract

We model demand-pressure effects on option prices. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of the unhedgeable parts of the two options. Empirically, we identify aggregate positions of dealers and end-users using a unique dataset, and show that demand-pressure effects make a contribution to well-known option-pricing puzzles. Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of index options, and cross-sectional tests show that demand impacts the expensiveness of single-stock options as well. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 22 (2009)
Issue (Month): 10 (October)
Pages: 4259-4299

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Handle: RePEc:oup:rfinst:v:22:y:2009:i:10:p:4259-4299

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