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Collateral smile

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  • Leippold, Markus
  • Su, Lujing

Abstract

We analyze the impact of funding costs and margin requirements on index options traded on the CBOE. Assuming differential borrowing and lending rates, we derive no-arbitrage bounds for European options. We show that funding costs and the CBOE’s margin requirements lead to a price increase, which translates into skew and smile patterns for implied volatility curves even under constant volatilities. Empirical tests confirm that our model-implied slopes have significant statistical power in explaining the slopes observed in the market. Hence, at least in part, funding costs and collateral requirements offer an institutional explanation of the volatility smile phenomenon.

Suggested Citation

  • Leippold, Markus & Su, Lujing, 2015. "Collateral smile," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 15-28.
  • Handle: RePEc:eee:jbfina:v:58:y:2015:i:c:p:15-28
    DOI: 10.1016/j.jbankfin.2015.03.019
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    References listed on IDEAS

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    1. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," The Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4259-4299, October.
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    4. Kamara, Avraham & Miller, Thomas W., 1995. "Daily and Intradaily Tests of European Put-Call Parity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(4), pages 519-539, December.
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    6. Santa-Clara, Pedro & Saretto, Alessio, 2009. "Option strategies: Good deals and margin calls," Journal of Financial Markets, Elsevier, vol. 12(3), pages 391-417, August.
    7. Kaushik Amin & Joshua D. Coval & H. Nejat Seyhun, 2004. "Index Option Prices and Stock Market Momentum," The Journal of Business, University of Chicago Press, vol. 77(4), pages 835-874, October.
    8. repec:bla:jfinan:v:59:y:2004:i:2:p:711-753 is not listed on IDEAS
    9. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," The Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
    10. Bing Han, 2008. "Investor Sentiment and Option Prices," The Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 387-414, January.
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    Cited by:

    1. Jensen, Mads Vestergaard & Pedersen, Lasse Heje, 2016. "Early option exercise: Never say never," Journal of Financial Economics, Elsevier, vol. 121(2), pages 278-299.

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    More about this item

    Keywords

    Collateral requirements; Funding costs; Volatility smile; Option pricing;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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