UNDERSTANDING COMPLEX DYNAMICS IN DERIVATIVES FINANCE: WHY DO OPTIONS MARKETS SMILE?

G. Qiu (), D. Kandhai (), N. F. Johnson () and P. M. A. Sloot ()
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G. Qiu: Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands
D. Kandhai: Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands
N. F. Johnson: Physics Department, University of Miami, Coral Gables, Florida 33124, USA
P. M. A. Sloot: Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands

Advances in Complex Systems (ACS), 2012, vol. 15, issue 07, 1-19

Abstract: The origin of the volatility smile phenomenon observed in options markets has eluded the financial world for more than two decades. We provide a new explanation of this phenomenon using a microscopic multi-agent description of markets. In our model individual trading behavior is explicitly included and the prices of the options are determined by demand and supply. Our results reproduce the empirical observations in respect to the shape and dynamic properties of the volatility smile, suggesting that this phenomenon is a natural consequence of traders' heterogeneous behavior and expectations about the future.

Keywords: Options markets; volatility smile; microsimulation (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (1)

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DOI: 10.1142/S0219525912500506

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