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On Feedback Effects from Hedging Derivatives

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  • Eckhard Platen
  • Martin Schweizer

Abstract

This paper proposes a new explanation for the smile and skewness effects in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly incorporating the technical demand induced by hedging strategies. This leads to a stochastic volatility endogenously determined by agents’ trading behavior. By using numerical methods for stochastic differential equations, we quantitatively substantiate the idea that option price distortions can be induced by feedback effects from hedging strategies.

Suggested Citation

  • Eckhard Platen & Martin Schweizer, 1998. "On Feedback Effects from Hedging Derivatives," Mathematical Finance, Wiley Blackwell, vol. 8(1), pages 67-84, January.
    • Handle: RePEc:bla:mathfi:v:8:y:1998:i:1:p:67-84
    DOI: 10.1111/1467-9965.00045
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