Title: Feedback trading and index option prices
Authors: Thorsten Lehnert - Luxembourg School of Finance (Luxembourg) [presenting]
Abstract: The channel through which mutual fund flows and stock return volatility are related is studied. Mutual fund investors are known to react on recent market conditions (past performance) and invest (withdraw) their money in (out of) mutual funds. Fund managers are forced to trade accordingly and, therefore, act as feedback traders. We examine whether S\& P 500 index option prices are affected by feedback trading. Our testing framework is a heterogeneous agents option pricing model, where some agents are not fully rational. Hence, our agents form different beliefs about the future level of market volatility, and trade options accordingly. We introduce feedback traders, who incorporate noisy signals into their volatility beliefs, next to agents who trade on long-term mean reversion in market volatility and agents who trade on exogenous shocks from the underlying market. The proposed option valuation framework is similar to a stochastic volatility model and is implemented using an augmented filtered historical simulation approach. We find that feedback trading appears to be an important determinant of index option prices. In addition, we find that feedback trading partly explains the term structure of the index option smile, because it primarily affects short-term options.