Project Details
Projekt
Intermediary Frictions, Dealer Positions, and Option Prices
Subject Area
Accounting and Finance
Term
since 2021
Project identifier
Deutsche Forschungsgemeinschaft (DFG) - Project number 447617473
The option market is a prime example of an intermediated market. Competitive dealers set prices relative to their costs in replicating the option’s payoff and end users trade on these prices for hedging, speculation, or risk management purposes. Unlike equities, options are in zero-net-supply, which brings into play how intermediaries on net will be exposed to risk. Clearly, option trading requires a higher degree of sophistication compared to trading on spot markets and arbitrage strategies are at the heart of derivatives pricing. Thus, very probably, sophisticated intermediaries instead of households are marginal investors there. If they are, we should expect frictions to shape the relation between intermediaries and option markets. In particular, market incompleteness and salient frictions such as market and funding illiquidity are crucial. They limit funding-constrained intermediaries’ risk-bearing capacity because of their inability to perfectly hedge risk and eventually lead prices to deviate from fundamentals. In contrast, the derivatives literature has associated derivative pricing with a more or less frictionless environment. In standard option pricing models, options are considered as being redundant assets that can be replicated through dynamic trading strategies in the underlying stock and the riskless asset. Our goal in this project is to theoretically and empirically analyze the impact of market liquidity and intermediary frictions on the resulting option prices, option returns, and option liquidity. In a first step, we develop a theoretical model to simultaneously derive option price levels and bid-ask spreads depending on the dealers’ positions, transaction costs in the underlying, and other asset market frictions. The model will give us first guidance in understanding the conditions under which frictions are reflected either in the price level or in the spread. We then empirically assess the relevance of our model predictions using equity options data and cross-sectional variation in dealer positions. We test our hypotheses on different levels of aggregation regarding dealers’ positions in similar option series and also analyze the persistence of the relations. Our empirical analysis depends on accurate empirical proxies for dealer positions, option liquidity, and delta hedged option returns. Comparing and benchmarking such measures will form a distinct methodological contribution of our project. In the last part, we analyze the impact of intermediary frictions over time. Our goal is to understand to what extent the impact of frictions on option prices depends on the general risk-bearing capacity of the intermediary sector.
DFG Programme
Research Units
