Modeling options markets by focusing on active tradersr (original) (raw)
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Modeling options markets by focusing on active traders
2010
In this work, we study the complex behavior of options markets characterized by the volatility smile phenomenon, through microsimulation (MS). We adopt two types of active traders in our MS model: speculators and arbitrageurs, and call and put options on one underlying asset. Speculators make decisions based on their expectations of the asset price at the option expiration time. Arbitrageurs trade at dierent arbitrage opportunities such as violation of put-call parity. Dierence in liquidity among options is also included. Notwithstanding its ...
Interest Rate Option Markets: The Role of Liquidity in Volatility Smiles
2004
We investigate the interaction of volatility smiles and liquidity in the euro (€) interest rate option markets, using daily bid and ask prices of interest rate caps/floors. We find that liquidity variables have significant explanatory power for both curvature and asymmetry of the implied volatility smiles. This effect is generally stronger on the ask side, indicating that ask-prices are more relevant for these markets. In addition, the shape of the implied volatility smile has some information about future levels and volatility of the term structure. Our results have important implications for the modeling and risk management of fixed income derivatives.
Behavioral heterogeneity in the option market
2010
This paper develops and tests a heterogeneous agents model for the option market. Our agents have differing beliefs about the level of volatility of the underlying stock index and trade accordingly. We consider two types of agents: fundamentalists, who are assumed to expect the conditional volatility to return to the unconditional volatility, and chartists who respond solely to noise from the level process. Agents are able to switch between groups according to a multinomial logit switching mechanism. The model simplifies to a GARCH-type specification with time-varying parameters, which depend on the distribution of agents across types. Estimation results for index options on the German DAX30 reveal that different types of traders are also actively involved in trading volatility. We find evidence that the observed patterns in option prices are the result of heterogeneity in expectations about future volatility.
The impact of liquidity on option prices
Journal of Futures Markets, 2011
This article illustrates the impact of both spot and option liquidity levels on option prices. Using implied volatility to measure the option price structure, our empirical results reveal that even after controlling for the systematic risk of Duan and Wei (2009), a clear link remains between option prices and liquidity; with a reduction (increase) in spot (option) liquidity, there is a corresponding increase in the level of the implied volatility curve. The former is consistent with the explanation on hedging costs provided by Cetin, Jarrow, Protter and Warachka (2006), whilst the latter is consistent with the 'illiquidity premium' hypothesis of Amihud and Mendelson (1986a). This study also shows that the slope of the implied volatility curve can be partially explained by option liquidity.
Market Illiquidity and the Bid-Ask Spread of Derivatives
FEUNL Working Paper Series, 2000
This paper analyzes the impact of illiquidity of a stock on the pricing of derivatives. In particular, it is shown how illiquidity generates a bid-ask spread in an option on this stock, even in the absence of other imperfections, such as transaction costs and asymmetry of information. Moreover, the spread is shown to be asymmetric with respect to the option price under perfect liquidity. This fact explains the appearance of a smile e¤ect when the implied volatility is estimated from the mid-quote.
Volatility, Market Structure, and the Bid-Ask Spread
Asia-Pacific Journal of Financial Studies, 2009
We test the conjecture that the specialist system on the New York Stock Exchange (NYSE) provides better liquidity services than the NASDAQ dealer market in times of high return volatility when adverse selection and inventory risks are high. We motivate our conjecture from the observation that there is a designated specialist for each stock on the NYSE who is directly responsible for maintaining a reasonable level of liquidity (i.e., the bid-ask spread) as the 'liquidity provider of last resort,' whereas there is no such designated dealer on NASDAQ. Empirical evidence is consistent with our conjecture. In a similar vein, we show that the specialist system provides better liquidity than the dealer market in thin markets. JEL classification: G18; G19
Journal of Economic Behavior & Organization, 2002
We propose a model with heterogeneous interacting traders which can explain some of the stylized facts of stock market returns. In the model, synchronization effects, which generate large fluctuations in returns, can arise purely from communication and imitation among traders. The key element in the model is the introduction of a trade friction which, by responding to price movements, creates a feedback mechanism on future trading and generates volatility clustering. The model also reproduces the empirically observed positive cross-correlation between volatility and trading volume.
The Effects of Option Trading Behavior on Option Prices
Journal of Risk and Financial Management
This paper investigates the relationship between option trading behavior and option pricing patterns. We argue that greater active trading in the options market due to investor overconfidence leads to higher volatility and larger discrepancies in option pricing, which may be captured by implied volatility spread and implied volatility skewness. Using two different measures of excess option trading, we find that trading activities are correlated in different ways with volatility, volatility spread, and volatility skewness. We also find that these relationships exist both over time and cross-sectionally. We suggest that options investors tend to chase “hot” stocks, as we find evidence of a positive relationship between option trading activities and past underlying equity returns. Heavier trading in the options market also tends to make out-of-the-money call options more (less) expensive than the at-the-money counterparts over time (cross-sectionally). Because trading activities do not...