Market Volatility and Feedback Effects from Dynamic Hedging

Rüdiger Frey, Alexander Stremme

Publication: Scientific journalJournal articlepeer-review


In this paper we analyze the manner in which the demand generated by dynamic hedging
strategies affects the equilibrium price of the underlying asset. We derive an explicit expression
for the transformation of market volatility under the impact of such strategies. It turns out
that volatility increases and becomes time and price dependent. The strength of these effects
however depends not only on the share of total demand that is due to hedging, but also
signifcantly on the heterogeneity of the distribution of hedged payoffs. We finally discuss in
what sense hedging strategies derived from the assumption of constant volatility may still be
appropriate even though their implementation obviously violates this assumption.
Original languageEnglish
Pages (from-to)351 - 374
JournalMathematical Finance
Issue number4
Publication statusPublished - 1 May 1997

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