MARKET VOLATILITY AND FEEDBACK EFFECTS FROM DYNAMIC HEDGING

In this paper we analyze the manner in which the demand generated by d ynamic hedging strategies affects the equilibrium price of the underly ing asset. We derive an explicit expression for the transformation of market volatility under the impact of such strategies. It turns out th at volatility increases and becomes time and price dependent. The stre ngth of these effects however depends not only on the share of total d emand that is due to hedging, but also significantly on the heterogene ity of the distribution of hedged payoffs. We finally discuss in what sense hedging strategies derived from the assumption of constant volat ility may still be appropriate even though their implementation obviou sly violates this assumption.