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Market Volatility and Feedback Effects from Dynamic Hedging

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  • Frey, Rüdiger
  • Alexander Stremme
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    Abstract

    In this paper we analyze in what way the demand generated by dynamic hedging strategies affects the equilibrium prices of the underlying asset. We derive an explicit expression for the transformation of market volatility under the impact of hedging. It turns out that market volatility increases and becomes price-dependent. The strength of the effects depend not only on the market share of portfolio insurance but also crucially on the heterogeneity of insured payoffs. We finally discuss in what sense hedging strategies calculated under the assumption of constant volatility are still appropriate, even if this assumption is obviously violated by their implementation.

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    File URL: http://www.wiwi.uni-bonn.de/bgsepapers/bonsfb/bonsfb310.pdf
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    Bibliographic Info

    Paper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 310.

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    Length: pages
    Date of creation: Oct 1995
    Date of revision:
    Handle: RePEc:bon:bonsfb:310

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    Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
    Fax: +49 228 73 6884
    Web page: http://www.bgse.uni-bonn.de

    Related research

    Keywords: Black--Scholes Model; Dynamic Hedging; Volatility; Option Pricing; Feedback Effects;

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    References

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    1. Leland, Hayne E, 1980. " Who Should Buy Portfolio Insurance?," Journal of Finance, American Finance Association, American Finance Association, vol. 35(2), pages 581-94, May.
    2. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers, University of California at Berkeley RPF-184, University of California at Berkeley.
    3. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, American Economic Association, vol. 70(3), pages 393-408, June.
    4. Jarrow, Robert A., 1994. "Derivative Security Markets, Market Manipulation, and Option Pricing Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 29(02), pages 241-261, June.
    5. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "Positive Feedback Investment Strategies and Destabilizing Rational Speculation," NBER Working Papers 2880, National Bureau of Economic Research, Inc.
    6. Grossman, Sanford J, 1988. "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 61(3), pages 275-98, July.
    7. Platen, Eckhard & Martin Schweizer, 1994. "On Smile and Skewness," Discussion Paper Serie B, University of Bonn, Germany 302, University of Bonn, Germany.
    8. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, American Finance Association, vol. 42(2), pages 281-300, June.
    9. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
    10. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
    11. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, Elsevier, vol. 11(3), pages 304-314, June.
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    Cited by:
    1. K. Ronnie Sircar & George Papanicolaou, 1998. "General Black-Scholes models accounting for increased market volatility from hedging strategies," Applied Mathematical Finance, Taylor & Francis Journals, Taylor & Francis Journals, vol. 5(1), pages 45-82.

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