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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Article provided by Oxford University Press for Society for Financial Studies in its journal The Review of Financial Studies.
Volume (Year): 22 (2009) Issue (Month): 10 (October) Pages: 4259-4299 Download reference. The following formats are available: HTML
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Paper
Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2005.
"Demand-Based Option Pricing,"
NBER Working Papers
11843, National Bureau of Economic Research, Inc.
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Shleifer, Andrei & Vishny, Robert W, 1997.
" The Limits of Arbitrage,"
Journal of Finance,
American Finance Association, vol. 52(1), pages 35-55, March.
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Jens Carsten Jackwerth & George M. Constantinaides & Stylianos Perrakis, 2005.
"Mispricing of S&P 500 Index Options,"
CoFE Discussion Paper
05-09, Center of Finance and Econometrics, University of Konstanz.
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Stylianos Perrakis & Jens Carsten Jackwerth & George Constantinides, 2005.
"Mispricing of S&P 500 Index Options,"
Working Papers
wp05-07, Warwick Business School, Financial Econometrics Research Centre.
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George M. Constantinides & Jens Carsten Jackwerth & Stylianos Perrakis, 2009.
"Mispricing of S&P 500 Index Options,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 22(3), pages 1247-1277, March.
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