Equilibrium Models for Derivatives Markets with Frictions

This thesis develops equilibrium models, and studies the effects of market frictions on risk-sharing, derivatives pricing, and trading patterns.

In the chapter titled "Imbalance-Based Option Pricing", I develop an equilibrium model of fragmented options markets in which option prices and bid-ask spreads are determined by the nonlinear risk imbalance between dealers and customers. In my model, dealers optimally exploit their market power and charge higher spreads for deep out-of-the-money (OTM) options, leading to an endogenous skew in both prices and spreads. In stark contrast to theories of price pressure in option markets, I show how wealth effects can make customers' net demand for options be negatively correlated with option prices. Under natural conditions, the skewness risk premium is positively correlated with the variance risk premium, consistent with the data.

In the chapter titled "The Demand for Commodity Options", we develop a simple equilibrium model in which commercial hedgers, i.e., producers and consumers, use commodity options and futures to hedge price and quantity risk. We derive an explicit relationship between expected futures returns and the hedgers' demand for out-of-the-money options, and show that the demand for both calls and puts are positively related to expected returns, and the relationship is asymmetric, tilted towards puts. We test and confirm the model predictions empirically using the commitment of traders report from CFTC.

In the chapter titled "Electronic Trading in OTC Markets vs. Centralized Exchange", we model a two-tiered market structure in which an investor can trade an asset on a trading platform with a set of dealers who in turn have access to an interdealer market. The investor's order is informative about the asset's payoff and dealers who were contacted by the investor use this information in the interdealer market. Increasing the number of contacted dealers lowers markups through competition but increases the dealers' costs of providing the asset through information leakage. We then compare a centralized market in which investors can trade among themselves in a central limit order book to a market in which investors have to use the electronic platform to trade the asset. With imperfect competition among dealers, investor welfare is higher in the centralized market if private values are strongly dispersed or if the mass of investors is large.