Option Market Making with Imperfect Competition

Option pricing models typically consider either monopolistic market makers, or settings with infinite competition. Real markets, however, are often dominated by a few large dealers with substantial market power. We study how... [ view full abstract ]

Option pricing models typically consider either monopolistic market makers, or settings with infinite competition. Real markets, however, are often dominated by a few large dealers with substantial market power. We study how such imperfect competition is reflected in equilibrium option prices.

To this end, we study a three-stage Stackelberg game of the following form. Dealers move first and quote competing price schedules. Clients then decide how many shares of the option to trade with each dealer. Finally, the dealers hedge their option positions in a market for the underlying of the option, where they interact through their common price impact.