Demand-Based Option Pricing

Abstract

We model demand-pressure effects on option prices. The model shows that demand pressure in one option contract increases its price by an amount pro- portional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount propor- tional 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 contribute to well-known option-pricing puzzles. In- deed, time-series tests show that demand helps explain the overall expensiveness and skew patterns of both index options and single-stock options