On Feedback Effects from Hedging Derivatives
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. Copyright Blackwell Publishers 1998.
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Volume (Year): 8 (1998)
Issue (Month): 1 ()
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References listed on IDEAS
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- Platen, Eckhard & Martin Schweizer, 1994. "On Smile and Skewness," Discussion Paper Serie B 302, University of Bonn, Germany.
- Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
- Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
- Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-43.
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