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N. Garleanu, L.H. Pedersen and A.M. Poteshman, “Demand-Based Option Pricing,” (Working paper, New York University, University of Pennsylvania, and University of Illinois at Urbana-Champaign, 22 February 2005).

N. Garleanu, L.H. Pedersen and A.M. Poteshman, “Demand-Based Option Pricing,” (Working paper, New York University, University of Pennsylvania, and University of Illinois at Urbana-Champaign, 22 February 2005).

Abstract: We model the demand-pressure effect on prices when options cannot be perfectly hedged. The model shows that demand pressure in one option contract increases its price by an amount proportional to the variance of the unhedgeable part of the option. Similarly, the demand pressure increases the price of any other option by an amount proportional to the covariance of their unhedgeable parts. Empirically, we identify aggregate positions of dealers and end users using a unique dataset, and show that demand-pressure effects help explain well-known option-pricing puzzles. First, end users are net long index options, especially out-of-money puts, which helps explain their apparent expensiveness and the smirk.Second, demand patterns help explain the cross section of prices and skews of single-stock options.