On Smile and Skewness
AbstractThis paper proposes a new explanation for the smile and skewness effects in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly incorporating the technical demand induced by hedging strategies. This leads to a stochastic volatility endogenously determined by agents' trading behaviour. Using numerical methods for stochastic differential equations, we quantitatively substantiate the idea that option price distortions can be induced by feedback effects from hedging strategies.
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Bibliographic InfoPaper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 302.
Date of creation: Dec 1994
Date of revision:
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option pricing; Black-Scholes formula; implied volatility; smile; skewness; stochastic volatility; feedback effects;
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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- E. Agliardi & R. Andergassen, 2002. "Feedback effects of dynamic hedging strategies in the presence of transaction costs," Working Papers 445, Dipartimento Scienze Economiche, Universita' di Bologna.
- Frey, Rüdiger, 1996. "The Pricing and Hedging of Options in Finitely Elastic Markets," Discussion Paper Serie B 372, University of Bonn, Germany.
- Jacquier, Eric & Jarrow, Robert, 2000. "Bayesian analysis of contingent claim model error," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 145-180.
- Mattias Jonsson & Jussi Keppo, 2002. "Option pricing for large agents," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(4), pages 261-272.
- Frey, Rüdiger & Alexander Stremme, 1995. "Market Volatility and Feedback Effects from Dynamic Hedging," Discussion Paper Serie B 310, University of Bonn, Germany.
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