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Collateral Smile

Author

Listed:
  • Markus LEIPPOLD

    (University of Zurich and Swiss Finance Institute)

  • Lujing SU

    (Universtiy of Zurich)

Abstract

We analyze the impact of funding costs and margin requirements on prices of index options traded on the CBOE. We propose a model that gives upper and lower bounds for option prices in the absence of arbitrage in an incomplete market with differential borrowing and lending rates. We show that funding costs and margin requirements cause a substantial increase in option prices, which translates into skew and smile patterns for implied volatility curves even under constant volatilities. Empirical tests show that the slopes our model generates have signi cant statistical power in explaining the slopes observed in the market.

Suggested Citation

  • Markus LEIPPOLD & Lujing SU, 2011. "Collateral Smile," Swiss Finance Institute Research Paper Series 11-51, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1151
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    References listed on IDEAS

    as
    1. Kamara, Avraham & Miller, Thomas W., 1995. "Daily and Intradaily Tests of European Put-Call Parity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(4), pages 519-539, December.
    2. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. "Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
    3. Santa-Clara, Pedro & Saretto, Alessio, 2009. "Option strategies: Good deals and margin calls," Journal of Financial Markets, Elsevier, vol. 12(3), pages 391-417, August.
    4. Kaushik Amin & Joshua D. Coval & H. Nejat Seyhun, 2004. "Index Option Prices and Stock Market Momentum," The Journal of Business, University of Chicago Press, vol. 77(4), pages 835-874, October.
    5. Nicolas P. B. Bollen & Robert E. Whaley, 2004. "Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?," Journal of Finance, American Finance Association, vol. 59(2), pages 711-753, April.
    6. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," The Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4259-4299, October.
    7. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," The Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
    8. George M. Constantinides & Jens Carsten Jackwerth & Stylianos Perrakis, 2009. "Mispricing of S&P 500 Index Options," The Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 1247-1277.
    9. Bing Han, 2008. "Investor Sentiment and Option Prices," The Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 387-414, January.
    10. Bergman, Yaacov Z, 1995. "Option Pricing with Differential Interest Rates," The Review of Financial Studies, Society for Financial Studies, vol. 8(2), pages 475-500.
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    Cited by:

    1. Jensen, Mads Vestergaard & Pedersen, Lasse Heje, 2016. "Early option exercise: Never say never," Journal of Financial Economics, Elsevier, vol. 121(2), pages 278-299.

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    More about this item

    Keywords

    collateral requirements; funding costs; volatility smile; option pricing;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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