Demand-Based Option Pricing

51 Pages Posted: 27 Mar 2006

See all articles by Nicolae Garleanu

Nicolae Garleanu

University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; New York University (NYU); Centre for Economic Policy Research (CEPR)

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: December 2005

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 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.

Keywords: Option, demand, valuation, intermediation, market makers, implied volatility, hedging, price pressure, risk, dealers

JEL Classification: G0, G12, G13, G14, G2

Suggested Citation

Garleanu, Nicolae Bogdan and Pedersen, Lasse Heje and Poteshman, Allen M., Demand-Based Option Pricing (December 2005). CEPR Discussion Paper No. 5420, Available at SSRN: https://ssrn.com/abstract=893587

Nicolae Bogdan Garleanu (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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Berkeley, CA 94720
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HOME PAGE: http://faculty.haas.berkeley.edu/garleanu

National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

New York University (NYU) ( email )

Stern School of Business
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New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Allen M. Poteshman

University of Illinois at Urbana-Champaign - Department of Finance ( email )

340 Wohlers Hall
1206 South Sixth Street
Champaign, IL 61820
United States
217-265-0565 (Phone)
217-244-3102 (Fax)

HOME PAGE: http://www.business.uiuc.edu/poteshma

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