ON FEEDBACK EFFECTS FROM HEDGING DERIVATIVES

This paper proposes a new explanation for the smile and skewness effec ts in implied volatilities. Starting from a microeconomic equilibrium approach, we develop a diffusion model for stock prices explicitly inc orporating the technical demand induced by hedging strategies. This le ads to a stochastic volatility endogenously determined by agents' trad ing behavior. By using numerical methods for stochastic differential e quations, we quantitatively substantiate the idea that option price di stortions can be induced by feedback effects from hedging strategies.