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Demand-Based Option Pricing

Nicolae Garleanu, Lasse Pedersen and Allen M. Poteshman

No 11843, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We model the demand-pressure effect on prices when options cannot be perfectly hedged. 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 their unhedgeable parts. Empirically, we identify aggregate positions of dealers and end users using a unique dataset, and show that demand-pressure effects help explain well-known option-pricing puzzles. First, end users are net long index options, especially out-of-money puts, which helps explain their apparent expensiveness and the smirk. Second, demand patterns help explain the prices of single-stock options.

JEL-codes: G0 G12 G13 G14 (search for similar items in EconPapers)
Date: 2005-12
New Economics Papers: this item is included in nep-fin, nep-mic and nep-mkt
Note: AP
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Published as Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(10), pages 4259-4299, October.

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