NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Demand-Based Option Pricing

Nicolae Garleanu, Lasse Heje Pedersen, Allen M. Poteshman

NBER Working Paper No. 11843
Issued in December 2005
NBER Program(s):   AP

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.

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Document Object Identifier (DOI): 10.3386/w11843

Published: 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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