A. Kalife (France)
: Non-linear market impact, bid-ask spread, portfolio risk management, insider trading. JEL codes: G11, G12, G21, G22
Due to the market imperfect liquidity in the presence of large traders, the usual delta-hedging strategy may change the equilibrium price dynamics, as highlights the G10 report in 1993. Market liquidity risk refers to the degree at which transaction flows affect asset prices, separately from any change in the economic fundamentals. In fact, large traders hold sufficient liquid assets to meet joint liquidity needs of other traders, behaving as market makers, and so bearing the risk of their im balanced derivatives portfolio. As a result of their dy namic hedging strategies, through endogenous non linear positive feedback effects from underlying asset prices to derivatives prices, they buy and sell deriva tives at prices shifted by an amount that depends on their derivatives net holding. This directly and en dogenously gives rise to empirically observed bid-ask spreads. But such a behaviour induces tricky gamma hedg ing positions, which requires creating vega positions in order to profit from the "feedback" volatility, at both long and short term, by trading both the vega and vega convexity. Furthermore the use of the in formation asymmetry about the specific structure of the options portfolio positions may be useful for inter temporal strategic hedging by the large player to the detriment of the small traders.
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