Identifying Demand Curves in Index Option Markets

Key Points

Demand curves in index option markets are not infinitely elastic, revealing underlying market structures.
Using a sign-restricted vector autoregression, the study emphasizes biases in treating net demand as exogenous.
Deteriorating market conditions lead to shifts in latent demand curves, affecting investment strategies.
End-user demand significantly predicts S&P 500 returns, enhancing understanding of market dynamics.

Abstract

We identify latent demands in index option markets using a sign-restricted vector autoregression (VAR) and highlight the bias from treating (equilibrium) net demand as exogenous. Market-maker and end-user demand curves are far from infinitely elastic as assumed by some models, but elasticities exceed existing estimates for equities. Characterizing demand curves provides insights into the structure of index option markets. Deteriorating market conditions are associated with right shifts of the latent demand curves. The at-the-money (ATM) (out-of-the-money (OTM)) markets for calls and puts are mainly driven by end-user (market-maker) demand, and end-user (market-maker) ATM (OTM) call option demand predicts S&P500 returns. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2023.04263 .

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Cite This Study

Jacobs et al. (Tue,) studied this question.

synapsesocial.com/papers/69a75a7fc6e9836116a205c9 https://doi.org/https://doi.org/10.1287/mnsc.2023.04263

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