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Asymmetric information about volatility and option markets

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  • Saikat Nandi

Abstract

This paper develops a model of asymmetric information in which an investor has information regarding the future volatility of the price process of an asset but not the future asset price. It is shown that there exists an equilibrium in which the investor trades an option on the asset and expressions for the equilibrium option price and the dynamic trading strategy of the investor are derived endogenously. It is found that the expected volatility of the underlying asset increases in the net order flow in the option market. Also, the depth of the option market is smaller when there is more uncertainty about the variance of the underlying asset, which is conceptually consistent with empirical findings in the equity option market.

Suggested Citation

  • Saikat Nandi, 1995. "Asymmetric information about volatility and option markets," FRB Atlanta Working Paper 95-19, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:95-19
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    File URL: https://www.frbatlanta.org/-/media/documents/research/publications/wp/1995/wp9519.pdf
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    References listed on IDEAS

    as
    1. George, Thomas J. & Longstaff, Francis A., 1993. "Bid-Ask Spreads and Trading Activity in the S&P 100 Index Options Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(3), pages 381-397, September.
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    4. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    7. Jameson, Mel & Wilhelm, William, 1992. "Market Making in the Options Markets and the Costs of Discrete Hedge Rebalancing," Journal of Finance, American Finance Association, vol. 47(2), pages 765-779, June.
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    Keywords

    options; Financial markets;

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