Impact of hedging pressure on implied volatility

Abstract

Previous research on the implied volatility smile focused on the relaxation of Black Scholes Options Pricing assumptions. However, empirical studies have shown these models (the time series structure of the GARCH model, the stochastic volatility model and the deterministic volatility model) have some major deficiencies. The hedging pressure theory assumed that the evolution of implied volatility of index options is mainly driven by the net buying pressure from large demand in the put options.

Based on the hedging pressure, this research examined the impact of the net buying pressure on the implied volatility change by using the FTSE 100 index options. The event of 9/11 affecting the implied volatility via the net buying pressure was also estimated. Further, this thesis also investigated whether the biases in using implied volatility to forecast volatility can be explained by the hedging pressure based on the instrumental variable regression.

When holding such constant effects as financial leverage, information flow and mean reversion, the net buying pressure of the out-of-the-money put options played a dominant role in determining the shape of the implied volatility, although the impact was transitory. The results also showed there was influence on the change in the implied volatility during the period of the event of 9/11. Finally, we found that the hedging pressure contributes to the difference between the implied volatility and the realized volatility although there are other unknown factors impacting on them.