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On Feedback Effects from Hedging Derivatives
Author(s) -
Platen Eckhard,
Schweizer Martin
Publication year - 1998
Publication title -
mathematical finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.98
H-Index - 81
eISSN - 1467-9965
pISSN - 0960-1627
DOI - 10.1111/1467-9965.00045
Subject(s) - economics , stochastic differential equation , skewness , econometrics , stochastic volatility , volatility (finance) , local volatility , stock price , mathematical economics , volatility smile , mathematics , paleontology , series (stratigraphy) , biology
This paper proposes a new explanation for the smile and skewness effects in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly incorporating the technical demand induced by hedging strategies. This leads to a stochastic volatility endogenously determined by agents’ trading behavior. By using numerical methods for stochastic differential equations, we quantitatively substantiate the idea that option price distortions can be induced by feedback effects from hedging strategies.