Market Volatility and Feedback Effects from Dynamic Hedging

Abstract

In this paper we analyze the manner in which the demand generated by dynamic hedging strategies a ects the equilibrium price of the underlying asset. We derive an explicit expression for the transformation of market volatility under the impact of such strategies. It turns out that volatility increases and becomes time and price dependent. The strength of these e ects however depends not only on the share of total demand that is due to hedging, but also signi cantly on the heterogeneity of the distribution of hedged payo s. We nally discuss in what sense hedging strategies derived from the assumption of constant volatility may still be appropriate even though their implementation obviously violates this assumption. JEL Classification: G10, G12, G13.

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@inproceedings{Stremme1997MarketVA, title={Market Volatility and Feedback Effects from Dynamic Hedging}, author={Alexander Stremme and Lucien Foldes and Dieter Sondermann and Nicole El Karoui and Darrell Du}, year={1997} }