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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- Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
- Jarrow, Robert A., 1994. "Derivative Security Markets, Market Manipulation, and Option Pricing Theory," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(02), pages 241-261, June.
- Platen, Eckhard & Martin Schweizer, 1994. "On Smile and Skewness," Discussion Paper Serie B 302, University of Bonn, Germany.
- Jin-Chuan Duan, 1995. "The Garch Option Pricing Model," Mathematical Finance, Wiley Blackwell, vol. 5(1), pages 13-32.
- Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
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