The impact of option hedging on the spot market volatility

We theoretically model and empirically quantify the feedback effect of delta hedging for spot market volatility forex market. start from an economy with two types traders, aggregated option maker (OMM) taker (OMT), whose exposures reflect total outstanding positions all traders in A different hedge ratio OMM OMT leads to a net activity, which introduces friction. represent this friction by simple linear permanent impact model. This approach allows us derive dependence on gamma exposure traders. Our theoretical shows that is increased (decreased) negative (positive) OMM, whereby amount increase depends executed To test model, we first reconstruct OMM’s using trade repository data find it negative. The empirical analysis performed over period 21st October 2017 30th June 2018 our reconstructed then strongly supports model: turns out be highly significant and, as expected, short exposure. Quantitatively, approximately −1000 billion USD (which around what observe data) absolute 0.7% EURUSD 0.9% USDJPY.