Market Volatility and Feedback Effects from Dynamic Hedging

Posted: 6 Sep 1999

See all articles by Rüdiger Frey

Rüdiger Frey

ETH Zürich

Alexander Stremme

University of Warwick - Finance Group

Date Written: March 1995

Abstract

In the paper we analyse in what way the implementation of dynamic hedging strategies affects the volatility of the underlying asset. To this end we first construct an economy where equilibrium prices are given by the classical Black- Scholes model of geometric Brownian Motion. Then we add program traders running dynamic hedging strategies into the model and study the resulting change of the diffusion process describing equilibrium asset prices. We derive an explicit formula for the transformation of market volatility under the impact of hedging. It turns out that volatility increases and becomes price-dependent. Moreover we discuss in what sense hedging strategies calculated under the assumption of constant volatility are still appropriate for the hedging of written option contracts even if the feedback effect of their implementation on prices is taken into account.

JEL Classification: G12, G13

Suggested Citation

Frey, Rüdiger and Stremme, Alexander, Market Volatility and Feedback Effects from Dynamic Hedging (March 1995). WBS Finance Group Research Paper No. 3, Available at SSRN: https://ssrn.com/abstract=6267

Rüdiger Frey (Contact Author)

ETH Zürich ( email )

ETH-Zentrum
CH-8092 Zurich
Switzerland
0041 1 63 26526 (Phone)
0041 1 63 21085 (Fax)

Alexander Stremme

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain
+44 (0) 2476 - 522 066 (Phone)
+44 (0) 2476 - 523 779 (Fax)

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