SFB 303 Discussion Paper No. B-302

Author: Platen, Eckhard, and Martin Schweizer
Title: On Smile and Skewness
Abstract: This paper proposes a new explanation for the smile and skewness effects in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly incorporating the technical demand induced by hedging strategies. This leads to a stochastic volatility endogenously determined by agents' trading behaviour. Using numerical methods for stochastic differential equations, we quantitatively substantiate the idea that option price distortions can be induced by feedback effects from hedging strategies.
Keywords: option pricing, Black-Scholes formula, implied volatility, smile, skewness, stochastic volatility, feedback effects
JEL-Classification-Number: G10, G13
Creation-Date: December 1994
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