The feedback effect of hedging in illiquid markets

This paper analyzes the influence of dynamic trading strategies on the pric es in financial markets. After a thorough discussion of the modeling issues involved we derive the modification of the stochastic process of the under lying asset that follows from the presence of dynamic trading strategies. W e analyze the nonlinear effects and the feedback from prices to trading str ategy. The pricing, hedging, and replication of options in the context of i lliquid markets is discussed and a nonlinear partial differential equation for an option replication strategy is derived. Finally the effects of one o f the most popular trading strategies-Put-option replication on the price o f the underlying asset are illustrated using numerical simulations.