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Options Prices, Insider Trading, and Interdealer Competition

Author

Listed:
  • Bruno Biais
  • Pierre Hillion

Abstract

This paper examines the formation of option transaction prices in an imperfect market where risk-averse dealers face liquidity and informed traders. Because of market imperfections, trading is costly and arbitrage pricing does not apply. Rather, the transaction prices are related to the dealers' reservation prices which, in turn, depend on risk and information adjusted expectations of the final value of the securities. The risk component reflects the fact that dealers manage a portfolio of options and attempt to minimize risk by minimizing the delta of their aggregate inventory positions. The information component reflects the fact that in the perfect Bayesian equilibrium analyzed in this paper the insiders find it optimal to trade certain classes of options more often than others.

Suggested Citation

  • Bruno Biais & Pierre Hillion, 1991. "Options Prices, Insider Trading, and Interdealer Competition," CEPR Financial Markets Paper 0015, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 33 Great Sutton Street, London EC1V 0DX..
    • Handle: RePEc:cpr:ceprfm:0015
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