Working Paper: NBER ID: w11843
Authors: Nicolae 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 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.
Keywords: Option Pricing; Demand Pressure; Implied Volatility; Market Dynamics
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 from end users (J23) | option prices (G13) |
| demand pressure from end users (J23) | implied volatility skew (C46) |
| demand patterns for single-stock options (C69) | pricing discrepancies between index options and single-stock options (G13) |
| demand pressure for index options (C69) | observed differences in implied volatility curves (G19) |