DP5420 Demand-Based Option Pricing

Author(s): Nicolae Bogdan Garleanu, Lasse Heje Pedersen, Allen M Poteshman
Publication Date: December 2005
Keyword(s): dealers, demand, hedging, implied volatility, intermediation, market makers, option, price pressure, risk, valuation
JEL(s): G0, G12, G13, G14, G2
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5420

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.