Market Volatility and Feedback Effects from Dynamic Hedging
AbstractIn 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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Bibliographic InfoPaper provided by University of Bonn, Germany in its series Discussion Paper Serie B with number 310.
Date of creation: Oct 1995
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Black--Scholes Model; Dynamic Hedging; Volatility; Option Pricing; Feedback Effects;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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