SFB 303 Discussion Paper No. B - 256

Author: Frey, Rüdiger, and Alexander Stremme
Title: Portfolio Insurance and Volatility - On the Robustness of the Black-Scholes Option Pricing Model
Abstract: We shall investigate the feedback effect that dynamical hedging strategies have on the price process of the underlying security, supposing the investors who run these strategies believe in the Black-Scholes option pricing theory. To this end we first construct within the general framework introduced by H. Föllmer and M. Schweizer in [FS 93] an economic environment in which security prices are given by the classical Black-Scholes model of geometric Brownian Motion. Then we introduce portfolio insurance into that model and study how the price process changes. It will turn out that the change of volatility depends not only on the weight of portfolio insurers' demand compared to total demand but also on the heterogeneity of the distribution of insured option contracts.
Keywords: Black-Scholes Model, Portfolio Insurance, Volatility
JEL-Classification-Number: 026, 313, 314, 521
Creation-Date: September 1993
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