Working Paper: CEPR ID: DP5420
Authors: Nicolae B. Garleanu; Lasse Heje Pedersen; Allen M. Poteshman
Abstract: 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 contribute to well-known option-pricing puzzles. Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of both index options and single-stock options.
Keywords: dealers; demand; hedging; implied volatility; intermediation; market makers; option price pressure; risk; valuation
JEL Codes: G0; G12; G13; G14; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| demand pressure in a specific option (C69) | price of the option (G13) |
| demand pressure in one option (C69) | prices of other options (G13) |
| demand pressure (J23) | increase in the pricing kernel in favorable states of nature (G19) |