RFS Advance Access originally published online on February 25, 2009
Review of Financial Studies 2009 22(10):4259-4299; doi:10.1093/rfs/hhp005
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Demand-Based Option Pricing
University of California at Berkeley, CEPR, and NBER
New York University, CEPR, and NBER
University of Illinois at Urbana-Champaign
Send correspondence to Nicolae Gârleanu, Haas School of Business, University of California, Berkeley, CA 94720-1900. E-mail: garleanu{at}haas.berkeley.edu.
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Abstract |
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We model demand-pressure effects on option prices. 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 the unhedgeable parts of the two options. Empirically, we identify aggregate positions of dealers and end-users using a unique dataset, and show that demand-pressure effects make a contribution to well-known option-pricing puzzles. Indeed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of index options, and cross-sectional tests show that demand impacts the expensiveness of single-stock options as well.
We are grateful for helpful comments from David Bates, Nick Bollen, Oleg Bondarenko, Menachem Brenner, Andrea Buraschi, Josh Coval, Domenico Cuoco, Apoorva Koticha, Sophie Ni, Jun Pan, Neil Pearson, Josh White, and especially from Steve Figlewski, as well as from seminar participants at the Caesarea Center Conference, Columbia University, Cornell University, Dartmouth University, Harvard University, HEC Lausanne, the 2005 Inquire Europe Conference, London Business School, the 2005 NBER Behavioral Finance Conference, the 2005 NBER Universities Research Conference, the NYU-ISE Conference on the Transformation of Option Trading, New York University, Nomura Securities, Oxford University, Stockholm Institute of Financial Research, Texas A&M University, University of California at Berkeley, University of Chicago, University of Illinois at Urbana-Champaign, University of Pennsylvania, University of Vienna, and the 2005 WFA Meetings.