Hedging in an equilibrium-based model for a large investor

TL;DR

This paper develops an equilibrium-based financial model to analyze how a large investor's trading impacts prices and hedging strategies in illiquid markets, considering the interaction with a market maker aiming to maximize expected wealth.

Contribution

It introduces a novel equilibrium model incorporating price impact effects for large investors trading in illiquid securities, focusing on contingent claims hedging.

Findings

Model captures the interaction between large investors and market makers.

Provides a framework for optimal hedging under price impact.

Analyzes the effect of market impact on hedging strategies.

Abstract

We study a financial model with a non-trivial price impact effect. In this model we consider the interaction of a large investor trading in an illiquid security, and a market maker who is quoting prices for this security. We assume that the market maker quotes the prices such that by taking the other side of the investor's demand, the market maker will arrive at maturity with maximal expected wealth. Within this model we concentrate on the issue of contingent claims' hedging.