The Feedback Effect of Hedging in Illiquid Markets

Abstract

This paper analyzes the influence of dynamic trading strategies on the prices in financial markets. After a thorough discussion of the modeling issues involved we derive the modification of the stochastic process of the underlying asset that follows from the presence of dynamic trading strategies. We analyze the nonlinear effects and the feedback from prices to trading strategy. The pricing, hedging, and replication of options in the context of illiquid markets is discussed and a nonlinear partial differential equation for an option replication strategy is derived. Finally the effects of one of the most popular trading strategies---Put-option replication---on the price of the underlying asset are illustrated using numerical simulations.