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Asymmetric information about volatility and option markets

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  • Saikat Nandi
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    Abstract

    This paper develops a model of asymmetric information in which an investor has information regarding the future volatility of the price process of an asset but not the future asset price. It is shown that there exists an equilibrium in which the investor trades an option on the asset and expressions for the equilibrium option price and the dynamic trading strategy of the investor are derived endogenously. It is found that the expected volatility of the underlying asset increases in the net order flow in the option market. Also, the depth of the option market is smaller when there is more uncertainty about the variance of the underlying asset, which is conceptually consistent with empirical findings in the equity option market.

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    File URL: http://www.frbatlanta.org/filelegacydocs/wp9519.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 95-19.

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    Date of creation: 1995
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    Publication status: Published in Journal of Derivatives Research, 1999
    Handle: RePEc:fip:fedawp:95-19

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    Keywords: Options (Finance) ; Financial markets;

    References

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    1. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    2. Lawrence R. Glosten & Paul R. Milgrom, 1983. "Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders," Discussion Papers 570, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
    4. Back, Kerry, 1993. "Asymmetric Information and Options," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 435-72.
    5. George, Thomas J. & Longstaff, Francis A., 1993. "Bid-Ask Spreads and Trading Activity in the S&P 100 Index Options Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(03), pages 381-397, September.
    6. Back, Kerry, 1992. "Insider Trading in Continuous Time," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 387-409.
    7. Jameson, Mel & Wilhelm, William, 1992. " Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing," Journal of Finance, American Finance Association, vol. 47(2), pages 765-79, June.
    8. Biais, Bruno & Hillion, Pierre, 1994. "Insider and Liquidity Trading in Stock and Options Markets," Review of Financial Studies, Society for Financial Studies, vol. 7(4), pages 743-80.
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