Discretionary Volatility Trading in Options Markets
Posted: 26 Aug 1999
Abstract
Under the assumption that the Black-Scholes option pricing formula can arise in equilibrium in a self-justifying manner (see Cherian and Jarrow [1995]), the presence of two different types of informed options traders interacting strategically will, under different market conditions, result in two forms of equilibria. In the first form, the two types of informed traders optimally separate their trades from each other by trading in different maturity options. In the second form, there will be a concentration of trading in the nearer maturity options market resulting in an increase in activity and liquidity in that market. Based on the observation that the market conditions for the latter equilibrium are consistent with empirically documented features of realized volatility, it is more likely that the latter equilibrium prevails. Finally, based on inferences from the model, some additional testable implications regarding the liquidity of call options markets under two scenarios are proposed.
JEL Classification: G13, G15
Suggested Citation: Suggested Citation