BFS 2002

Contributed Talk

Equilibrium Option Pricing with Illiquid Underlying: Monopoly and Competition Between Market-Makers

João Amaro de Matos, Paula Antão

Under perfect market equilibrium, option prices are determined as if the economic agents were risk neutral. This paper develops a simple two-period model to analyze the impact of imperfect hedging on the equilibrium pricing of derivatives. In a partial equilibrium analysis, we show how a bid-ask option price spread is generated. In particular, we show how the equilibrium bid and ask prices depend on the market-makers' risk aversion and competition between market-makers. We argue that a monopolist market-maker is crucial to the existence of a Nash equilibrium in prices. Neither transaction costs nor asymmetric information are considered.