The shape of option implied volatility: a study based on market net demand pressure

Purpose–Due to disequilibrium between supply and demand in the option market, the option market-maker is under exposure to certain risks because of their net option positions. This paper aims to pay attention to whether the risk award affects the option price and the shape of implied volatility in the market-maker system. Design/methodology/approach–The paper first eliminates the part of implied volatility explained by underlying asset's stochastic volatility-jump price process, and second sorts out market investors' net demand data from TAIEX Options tick by tick deal data and then finally considers three market maker's risks – unhedgeable risk, capital constrain risk and asymmetric information risk, and how they affect implied volatility's level and slope. Findings–Through the research in the TAIEX Option market, the paper finds that, under unhedgeable risk, net demand pressure has a significant impact on implied volatility. Especially, unhedgeable risk due to underlying asset's stochastic volatility has the best explanation for implied volatility level, and unhedgeable risk due to underlying asset's jump can explain implied volatility slope to some extent. Capital constrain risk and asymmetric information risk have an insignificant impact on implied volatility. Research limitations/implications–The findings in this study suggest that the risk award affects the option price and the shape of implied volatility in the market-maker system and different risks have different effects on the level and slope of option implied volatility. Practical implications–This paper finds the influence factors of the option price in the market-maker system. It's useful for China's financial government and investors to learn the price tendency and regular pattern in the future China option market. Originality/value–This is the first time that a net demand pressure based option pricing model is used, which is derived by Garleanu, Pedersen and Poteshman, to study the TAIEX Options' implied volatility. And the paper improves the methods eliminating the part of implied volatility explained by underlying asset's stochastic volatility-jump price process.