Derivative Security Induced Price Manipulation
This paper investigates the potential contribution of cash market price manipulation to an option's value. When the underlying's transaction price follows an exogeneous fundamental process plus a price impact component influenced by trade, both sides of an option position may try to move the underlying cash price. Optimal cash trading strategies consist of a manipulation component and a liquidity provision for the other traders in the market. When the price impact is transitory, the optimal cash strategy may involve ``pre-liquidation'' of manipulative cash trades to reduce trading costs. We find that cash market manipulation can represent a significant portion of an option's value. The price impact of manipulation can be non-monotonic and the optimal cash trading strategy can be discontinuous in the number of longs and shorts.
Authors: | Gallmeyer, Michael ; Seppi, Duane |
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Institutions: | Carnegie Mellon University, Tepper School of Business |
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