Demand-Based Option Pricing
University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
Lasse Heje Pedersen
New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)
Allen M. Poteshman
University of Illinois at Urbana-Champaign - Department of Finance
NBER Working Paper No. w11843
We model the demand-pressure effect on prices when options cannot be perfectly hedged. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of their unhedgeable parts. Empirically, we identify aggregate positions of dealers and end users using a unique dataset, and show that demand-pressure effects help explain well-known option-pricing puzzles. First, end users are net long index options, especially out-of-money puts, which helps explain their apparent expensiveness and the smirk. Second, demand patterns help explain the prices of single-stock options.
Number of Pages in PDF File: 49working papers series
Date posted: March 29, 2006
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