## Understanding Asset Price Dynamics in the Presence of Option Hedging, Circuit Breakers and Cash Flow Growth

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Author

Date

2021Type

- Doctoral Thesis

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Abstract

This dissertation is a compilation of four self-contained research papers that contribute to the literature of financial economics. All papers are co-authored by Professor Didier Sornette, my thesis supervisor, and further, depending on the project, by other authors. While three papers presented in this thesis were submitted to leading, peer-reviewed journals and are either awaiting review or are on revise and resubmit status, one paper is work in progress (the respective status is shown in the references as well as on the paper title page). The papers as presented in the thesis can include additional material that goes beyond the versions submitted.
Understanding the formation and dynamics of asset prices is essential for many regulatory, policy and investment decisions. Chapter 2 and 3 of this dissertation aim to cast light into the dynamics of asset prices in the presence of two feedback effects, option markets and circuit breakers, using relative pricing models. Chapter 4 presents an absolute asset pricing model that provides a framework on how to correctly value firms in the presence of high clash flow growth.
First, chapter 2 presents the discussion of a feedback effect between markets, namely from the options market onto the underlying’s market. We show that if the option market makers (OMM) hedge a larger share of their position compared to option market takers (OMT), this leads to a net delta hedge demand in the spot market. And due to liquidity effects (price impact), this mechanically leads to an increase or decrease in the underlying’s price volatility and a distortion of the underlying’s drift, depending on the positioning of the option market. We describe this dynamic with a relative pricing model, relative to the price without option hedging. Then we focus on the impact of option hedging on the spot markets volatility in the foreign exchange (FX) market. We use trade repository data to estimate the net positioning of the OMM in the FX options market and with it her delta hedge demand in the spot market. We find the OMM to be short gamma on average (implying she has a short option positioning on average) and thus the volatility to be increased by delta hedging of the OMM. Next, we an- alyze the impact of option hedging on the price stability. Using theoretical arguments as well as simulations, we show that the probability for drift bursts, i.e. explosive directional price moves, can be increased or decreased due to option positioning, depending on the option parameters and delta of the OMM. Using option positioning data for the GameStock stock, we document that there are indeed instances where explosive trends due to hedging were more likely in the first quarter of 2021, during which the stock showed exceptional price instability.
Second, chapter 3 presents the discussion of a feedback effect that stems from the market architecture of exchanges, i.e. the price dynamics of so called circuit breakers (CB). A price-based CB for example is a trading halt imposed by an exchange after the price drops below (or rises above) a pre-specified value within a trading session. The rational behind a CB mechanism is that it gives traders time to calm down, interact with their counterparts and rethink their trading decision. Given that investors are continuously forming anticipations, their tactical positioning in the presence of the CB may lead to feedback of the CB on the price itself. We model the price dynamic under a CB using a relative pricing model, relative to the price without a CB, in a closed-form setup, in which the investors’ anticipation of the probability of a halt feedbacks on the price. In a general stochastic financial framework, this leads to coupled integral and stochastic differential equations. Our theory confirms two observations of this field for price-based CBs, namely an increased price volatility prior to the trigger and a negative effect of attracting the price to the CB level (known as the magnet effect). As our framework generalises to other CB mechanisms, we can then suggest a new CB design which minimises the adverse effects of a price-based CB. We e.g. show that a trading halt that is conditioned on a pre-specified volatility level, instead of a price level, mitigates the side effects.
Third, chapter 4 contributes to the discipline of absolute asset pricing. We aim to refocus the discussion around what could be loosely referred to as an expected return factor. Motivated by economic intuition and empirical insights from the consumption-based capital asset pricing model we show that the expected return on a firm level has a linear relationship to the firm’s cash flow growth level. With that we argue that the discount rate should reflect this linear relationship and should thus have the same term structure as the assumed cash flow growth rate process. Based on that we first introduce a discounted cash flow (CDF) model with a time-varying discount rate matching the assumed cash flow growth rate process. This important feature greatly enhances the value of a DCF model, as the valuation is less sensitive to the cash flow growth rate process assumptions, as the discount rate is proportional to the assumed cash flow growth rate term structure, such that these two naturally complementary variables interact to massively reduce the range of reasonable valuation outcomes. Second, using the same time-varying discount rate in an internal cost of capital (ICC) model, we elaborate that the corresponding time-varying internal rate of return allows for a straightforward interpretation as investment return of a buy and hold strategy, compared to e.g. a constant ICC model, which by construction is a constant compound return. We show that our expected return proxy is superior in explaining realised returns compared to a constant internal rate of return, and even renders well known linear factors, which can be motivated from theory, insignificant. Last, the economic significance is confirmed in a trading strategy with yearly rebalancing. Show more

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https://doi.org/10.3929/ethz-b-000526014Publication status

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Publisher

ETH ZurichSubject

Valuation; OPTIONS (FINANCE); Hedging; Price impact; CASH FLOW (ACCOUNTING); Circuit Breaker; Mathematical Finance; ECONOMICS; FINANCE; Expected Returns; Cost of capital; Discounted cash flow method; Discounted cash flow; investing in stocks; Trading strategy; Stock returnsOrganisational unit

03738 - Sornette, Didier (emeritus) / Sornette, Didier (emeritus)
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