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A Tractable Framework for Option Pricing with Dynamic Market Maker Inventory and Wealth

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  • Fournier, Mathieu
  • Jacobs, Kris

Abstract

We develop a tractable dynamic model of an index option market maker with limited capital. We solve for the variance risk premium and option prices as a function of the asset dynamics and market maker option holdings and wealth. The market maker absorbs end users’ positive demand and requires a more negative variance risk premium when she incurs losses. We estimate the model using returns, options, and inventory and find that it performs well, especially during the financial crisis. The restrictions imposed by nested existing reduced-form stochastic-volatility models are strongly rejected in favor of the model with a market maker.

Suggested Citation

  • Fournier, Mathieu & Jacobs, Kris, 2020. "A Tractable Framework for Option Pricing with Dynamic Market Maker Inventory and Wealth," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(4), pages 1117-1162, June.
    • Handle: RePEc:cup:jfinqa:v:55:y:2020:i:4:p:1117-1162_3
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    Cited by:

    1. Libo Yin & Jing Nie, 2021. "Intermediary asset pricing in currency carry trade returns," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(8), pages 1241-1267, August.
    2. Kanne, Stefan & Korn, Olaf & Uhrig-Homburg, Marliese, 2023. "Stock illiquidity and option returns," Journal of Financial Markets, Elsevier, vol. 63(C).
    3. Jacobs, Kris & Mai, Anh Thu, 2024. "The role of intermediaries in derivatives markets: Evidence from VIX options," Journal of Empirical Finance, Elsevier, vol. 77(C).
    4. Feng, Ling & Wang, Jieyu, 2023. "Random sources correlations and carbon futures pricing," International Review of Financial Analysis, Elsevier, vol. 86(C).
    5. Gruenthaler, Thomas & Lorenz, Friedrich & Meyerhof, Paul, 2022. "Option-based intermediary leverage," Journal of Banking & Finance, Elsevier, vol. 145(C).

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