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Understanding Complex Dynamics In Derivatives Finance: Why Do Options Markets Smile?

Author

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  • G. QIU

    (Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands)

  • D. KANDHAI

    (Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands)

  • N. F. JOHNSON

    (Physics Department, University of Miami, Coral Gables, Florida 33124, USA)

  • P. M. A. SLOOT

    (Computational Science, Faculty of Science, University of Amsterdam, Science Park 904, 1098 XH Amsterdam, The Netherlands)

Abstract

The origin of the volatility smile phenomenon observed in options markets has eluded the financial world for more than two decades. We provide a new explanation of this phenomenon using a microscopic multi-agent description of markets. In our model individual trading behavior is explicitly included and the prices of the options are determined by demand and supply. Our results reproduce the empirical observations in respect to the shape and dynamic properties of the volatility smile, suggesting that this phenomenon is a natural consequence of traders' heterogeneous behavior and expectations about the future.

Suggested Citation

  • G. Qiu & D. Kandhai & N. F. Johnson & P. M. A. Sloot, 2012. "Understanding Complex Dynamics In Derivatives Finance: Why Do Options Markets Smile?," Advances in Complex Systems (ACS), World Scientific Publishing Co. Pte. Ltd., vol. 15(07), pages 1-19.
    • Handle: RePEc:wsi:acsxxx:v:15:y:2012:i:07:n:s0219525912500506
    DOI: 10.1142/S0219525912500506
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    References listed on IDEAS

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    1. repec:dau:papers:123456789/607 is not listed on IDEAS
    2. Levy, Haim & Levy, Moshe & Solomon, Sorin, 2000. "Microscopic Simulation of Financial Markets," Elsevier Monographs, Elsevier, edition 1, number 9780124458901.
    3. Helyette Geman, 2005. "Commodities and Commodity Derivatives. Modeling and Pricing for Agriculturals, Metals and Energy," Post-Print halshs-00144182, HAL.
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    Cited by:

    1. Liu, Yi-Fang & Zhang, Wei & Xu, Hai-Chuan, 2014. "Collective behavior and options volatility smile: An agent-based explanation," Economic Modelling, Elsevier, vol. 39(C), pages 232-239.

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