A Tractable Framework for Option Pricing with Dynamic Market Maker Inventory and Wealth

76 Pages Posted: 2 Oct 2013 Last revised: 28 Feb 2018

See all articles by Mathieu Fournier

Mathieu Fournier

UNSW Business School

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Date Written: February 23, 2018

Abstract

We develop a tractable dynamic model of an index option market maker with limited capital and characterize how option prices depend on inventory risk and market maker wealth. The risk averse market maker absorbs positive demand by end users and requires a more negative variance risk premium when she incurs losses. The model is parsimonious and nests existing reduced-form stochastic-volatility models. We estimate the model using returns, options, and inventory and find that it performs well, especially during the financial crisis. The restrictions imposed by existing stochastic-volatility models are strongly rejected in favor of the model with a market maker.

Keywords: Variance risk premium; market maker; inventory risk; financial constraints; option pricing

JEL Classification: G10, G12, G13

Suggested Citation

Fournier, Mathieu and Jacobs, Kris, A Tractable Framework for Option Pricing with Dynamic Market Maker Inventory and Wealth (February 23, 2018). Rotman School of Management Working Paper No. 2334842, Available at SSRN: https://ssrn.com/abstract=2334842 or http://dx.doi.org/10.2139/ssrn.2334842

Mathieu Fournier (Contact Author)

UNSW Business School ( email )

UNSW Business School
High St
Sydney, NSW 2052
Australia

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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