Understanding complex dynamics in derivatives finance: Why do options markets smile?

G. Qiu; D. Kandhai; N. F. Johnson; P. M.A. Sloot

doi:10.1142/S0219525912500506

Understanding complex dynamics in derivatives finance: Why do options markets smile?

G. Qiu, D. Kandhai, N. F. Johnson, P. M.A. Sloot

Physics

Research output: Contribution to journal › Article › peer-review

3 Scopus citations

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.

Original language	English (US)
Article number	1250050
Journal	Advances in Complex Systems
Volume	15
Issue number	7
DOIs	https://doi.org/10.1142/S0219525912500506
State	Published - Oct 2012

Keywords

Microsimulation
Options markets
Volatility smile

ASJC Scopus subject areas

Control and Systems Engineering

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10.1142/S0219525912500506

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title = "Understanding complex dynamics in derivatives finance: Why do options markets smile?",

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.",

keywords = "Microsimulation, Options markets, Volatility smile",

author = "G. Qiu and D. Kandhai and Johnson, {N. F.} and Sloot, {P. M.A.}",

note = "Funding Information: We wish to thank Besiana Rexhepi for performing part of the empirical data analysis. This work was carried out in the context of VLe (Virtual Laboratory for eScience), a project supported by a BSIK grant from the Dutch Ministry of Education, Culture and Science. Copyright: Copyright 2012 Elsevier B.V., All rights reserved.",

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N1 - Funding Information: We wish to thank Besiana Rexhepi for performing part of the empirical data analysis. This work was carried out in the context of VLe (Virtual Laboratory for eScience), a project supported by a BSIK grant from the Dutch Ministry of Education, Culture and Science. Copyright: Copyright 2012 Elsevier B.V., All rights reserved.

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N2 - 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.

AB - 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.

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KW - Volatility smile

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Understanding complex dynamics in derivatives finance: Why do options markets smile?

Abstract

Keywords

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