## Abstract

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.

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 language | English |
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Pages (from-to) | 351 - 374 |

Journal | Mathematical Finance |

Volume | 7 |

Issue number | 4 |

Publication status | Published - 1 May 1997 |