How Does High Frequency Risk Hedge Activity Have an Affect on Underlying Market?: Analysis by Artificial Market Model

Abstract

The effect of option markets on their underlying markets has been studied intensively since the first option contract was listed. Despite considerable effort, including the development of theoretical and empirical approaches, we do not yet have conclusive evidence on this effect. We investigate the effect of option markets, especially that of dynamic hedging, on their underlying markets by using an artificial market. We propose a two-market model in which an option market and its underlying market interact. In our model, there are three types of agents, underlying local agents trading only on the underlying market, option local agents who trade only on the option market, and global agents who trade both on the underlying and the option market. In this simulation, we investigate the effect of hedgers, a global agent, to the underlying market. Hedgers who have option contracts trade the underlying asset to keep a delta neutral position. This hedge behavior is called dynamic hedging. We simulate two scenarios; one is the hedge with low frequency and the other is the hedge with high frequency that hedger can send hedge order anytime when hedge miss appears. We confirmed that dynamic hedging increases or decreases the volatility of the underlying market under certain conditions.