Direct exchange mechanisms for option pricing

Abstract

This paper presents the design and simulation of direct exchange mechanisms for pricing European options. It extends McAfee's single-unit double auction to multi-unit format, and then applies it for pricing options through aggregating agent predictions of future asset prices. We will also propose the design of a combinatorial exchange for the simulation of agents using option trading strategies. We present several option trading strategies that are commonly used in real option markets to minimise the risk of future loss, and assume that agents can submit them as a combinatorial bid to the market maker. We provide simulation results for proposed mechanisms, and compare them with existing Black-Scholes model mostly used for option pricing. The simulation also tests the effect of supply and demand changes on option prices. It also takes into account agents with different implied volatility. We also observe how option prices are affected by the agents’ choices of option trading strategies.