Project Details
Projekt
Intermediary Frictions, Dealer Positions, and Option Prices
Subject Area
Accounting and Finance
Term
since 2021
Project identifier
Deutsche Forschungsgemeinschaft (DFG) - Project number 447617473
The option market is a prime example of an intermediated market. Competitive dealers set prices relative to their costs in replicating the option’s payoff and end users trade on these prices for hedging, speculation, or risk management purposes. Unlike equities, options are in zero-net-supply, which brings into play how intermediaries on net will be exposed to risk. Clearly, option trading requires a higher degree of sophistication compared to trading on spot markets and arbitrage strategies are at the heart of derivatives pricing. Thus, very probably, sophisticated intermediaries instead of households are marginal investors there. If they are, we should expect frictions to shape the relation between intermediaries and option markets. In particular, market incompleteness and salient frictions such as market and funding illiquidity are crucial. They limit funding-constrained intermediaries’ risk-bearing capacity because of their inability to perfectly hedge risk and eventually lead prices to deviate from fundamentals. In contrast, the derivatives literature has associated derivative pricing with a more or less frictionless environment. In standard option pricing models, options are considered as being redundant assets that can be replicated through dynamic trading strategies in the underlying stock and the riskless asset. Our goal in this project is to explore the role of intermediaries and their frictions in options markets, building on our enhanced methodological measures for option returns, option liquidity, and dealer. On the one hand, these measures allow us to examine the unresolved relation between option liquidity and option returns. On the other hand, we utilize them to critically reassess influential prior intermediary asset pricing studies in options markets. Finally, we adopt a demand-based asset pricing framework for options, examining with simulation studies how to integrate short positions and interrelated option dynamics, and subsequently applying the refined model to real-world demand data.
DFG Programme
Research Units
