Managing investment and liquidity risks for derivatives within a market impact perspective
Open Access
- 27 December 2017
- journal article
- Published by LLC CPC Business Perspectives in Insurance Markets and Companies
- Vol. 8 (1), 59-73
- https://doi.org/10.21511/ins.08(1).2017.06
Abstract
The recent period has experienced many instances when market volatility suddenly increased even when there were no well-known fundamental catalysts, as illustrated by the short-lived but sharp transitions from low volatility to high volatility, as many in the last six years as we have had in the prior two decades ‒ increasing evidence that we are in a new volatility-of-volatility regime. Fundamentally, market impact is an illustration of market inefficiency: theories of efficient markets typically expect that investors buy and sell assets based on assessments of their intrinsic value, in contrast with large derivative players who often act based on market price movements which may not be linked to fundamentals. Market impact risk refers to the degree to which large size transactions can be carried out in a timely fashion with a minimal impact on prices. As a result, managing investment and liquidity risks for large players requires introducing an explicit market impact function, and applying to derivatives significantly depends on whether there is or not significant delta hedging activity: in case of no significant delta hedging activity, the risk appetite has significant influence on the optimal execution strategy, while in case of significant delta hedging activity the optimal trading involves feedback hedging effects translating into a modified Black ‒ Scholes hedging strategy.Keywords
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