ExperimentalFinanceLecture-3F

ExperimentalFinanceLecture-3F - Experimental Finance IEOR...

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Experimental Finance IEOR – Spring 2012 Mike Lipkin, Pankaj Mody
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2/2/12Experimental Finance Mike Lipkin, Alexander Stanton Page 2 Lecture 3f Pinning KO last week pinning to 67.50 (weeklies)
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Experimental Finance Mike Lipkin, Alexander Stanton Page 3 Lecture 3f Pinning
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Experimental Finance Mike Lipkin, Alexander Stanton Page 4 Lecture 3f Pinning Today we want to look at a static property of the option markets. Not all phenomena which appear to violate l standard z option theory are dynamic. As you know, there are many assumptions made in standard classical finance which we know, or suspect, cannot hold in the real markets. Suppose you see the following market: XYZ Jun 40 C 8.50 – 8.80 (100 x 450) (Underlying) 48.46 48.52 (650 x 75) Expiration day. First of all, what does this mean? What is the fair value of the calls? Classical theory says that the Jun 40 calls are overpriced. By how much? Why haven ` t they traded?
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Experimental Finance Mike Lipkin, Alexander Stanton Page 5 Lecture 3f Pinning Costs are an obvious area typically ignored in order to price options. A more subtle idea is the assumption of a stock process . This is a stochastic process for the stock, independent of the presence of options trading. Suppose someone bids for 25000 calls all at once. (On Friday, April 28, 2006 this happened in MSFT May 25 (at-the-$) calls.) Do you suspect that the stock would move in a correlated fashion? Which way? (In MSFT the stock price moved from 24.05 to 24.17 in 15 minutes from the origin of the order.) This means that on certain time scales a demand for (supply of) stock moves the stock. Quantifying this effect theoretically means identifying an Impact Function . What about the very presence of outstanding option open interest? Typically it would seem not, because undoubtedly positions are hedged. And yet, sometimes option positions lead to changing deltas.
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Experimental Finance Mike Lipkin, Alexander Stanton Page 6 Lecture 3f Pinning Suppose you hold an XYZ Jun 40 C; it is expiration day and the stock is at 40.35 at 10:30. You calculate the delta and find it is 58. At 1:30, three hours later, the stock is still at 40.35. What has happened to the delta of the call? When you recalculate the option delta, it is now 66. Why? To stay delta-neutral you must sell an additional 8 shares. Now couple this to the assumption that supply (demand) of the stock pushes the stock down (up) and the changing deltas of the option lead to long option holders selling the stock. An analogous argument applies with the stock below the strike; now buyers push the stock up toward the strike. In the Black-Scholes, classical world, there are an equal number of short option holders doing the exact opposite thing. The net effect should be zero.
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Experimental Finance Mike Lipkin, Alexander Stanton Page 7 Lecture 3f Pinning But is this an accurate assumption? Market makers are generally active hedgers. When they are long a strike they aggressively hedge, especially
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ExperimentalFinanceLecture-3F - Experimental Finance IEOR...

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