SFB 303 Discussion Paper No. B-310

Author: Frey, Rüdiger, and Alexander Stremme
Title: Market Volatility and Feedback Effects from Dynamic Hedging
Abstract: In this paper we analyze in what way the demand generated by dynamic hedging strategies affects the equilibrium prices of the underlying asset. We derive an explicit expression for the transformation of market volatility under the impact of hedging. It turns out that market volatility increases and becomes price-dependent. The strength of the effects depend not only on the market share of portfolio insurance but also crucially on the heterogeneity of insured payoffs. We finally discuss in what sense hedging strategies calculated under the assumption of constant volatility are still appropriate, even if this assumption is obviously violated by their implementation.
Keywords: Black--Scholes Model, Dynamic Hedging, Volatility, Option Pricing, Feedback Effects
JEL-Classification-Number: G13
Creation-Date: October 1995
URL: ../1995/b/bonnsfb310.pdf

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