Pricing and hedging of derivative securities: Some effects of asymmetric information and market power.

This thesis consists of a collection of studies investigating various aspects of the interplay between the markets for derivative securities and their respective underlying assets in the presence of market imperfections. The classic theory of derivative pricing and hedging hinges on three rather unrealistic assumptions regarding the market for the underlying asset. Markets are assumed to be perfectly elastic, complete and frictionless. This thesis studies some effects of relaxing one or more of these assumptions. Chapter 1 provides an introduction to the thesis, details the structure of what follows, and gives a selective review of the relevant literature. Chapter 2 focuses on the effects that the implementation of hedging strategies has on equilibrium asset prices when markets are imperfectly elastic. The results show that the feedback effect caused by such hedging strategies generates excess volatility of equilibrium asset prices, thus violating the very assumptions from which these strategies are derived. However, it is shown that hedging is nonetheless possible, albeit at a slightly higher price. In Chapter 3, a model is developed which describes equilibrium asset prices when market participants use technical trading rules. The results confirm that technical trading leads to the emergence of speculative price "bubbles". However, it is shown that although technical trading rules are irrational ex-ante, they turn out to be profitable ex-post. In Chapter 4, a general framework is developed in which the optimal trading behaviour of a large, informed trader can be studied in an environment where markets are imperfectly elastic. It is shown how the optimal trading pattern changes when the large trader is allowed to hold options written on the traded asset. In Chapter 5, the results of the preceding chapter are used to study the interplay between options markets and the markets for the underlying assets when prices are set by a market maker. It turns out that the existence of the option creates an incentive for the informed trader to manipulate markets, which implies that equilibrium on both markets can only exist when option prices are adjusted to reflect this incentive. This requirement of price alignment explains the "smile" pattern of implied volatility, an empirically observed phenomenon that has recently been the focus of extensive research. Chapter 6 finally addresses recent proposals by some researchers suggesting that central banks should issue options in order to stabilise exchange rates. The argument, in line with the findings of Chapter 2, is based on the fact that hedging a long option position requires countercyclical trading that would reduce volatility. However, the results of Chapter 6 show that the option creates an incentive for market manipulation which, rather than protecting against speculative attacks, in fact creates an additional vehicle for such attacks. Chapter 7 concludes