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Model Uncertainty and Option Markets with Heterogeneous Beliefs

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  • ANDREA BURASCHI
  • ALEXEI JILTSOV

Abstract

This paper provides option pricing and volume implications for an economy with heterogeneous agents who face model uncertainty and have different beliefs on expected returns. Market incompleteness makes options nonredundant, while heterogeneity creates a link between differences in beliefs and option volumes. We solve for both option prices and volumes and test the joint empirical implications using S&P500 index option data. Specifically, we use survey data to build an Index of Dispersion in Beliefs and find that a model that takes information heterogeneity into account can explain the dynamics of option volume and the smile better than can reduced‐form models with stochastic volatility.

Suggested Citation

  • Andrea Buraschi & Alexei Jiltsov, 2006. "Model Uncertainty and Option Markets with Heterogeneous Beliefs," Journal of Finance, American Finance Association, vol. 61(6), pages 2841-2897, December.
    • Handle: RePEc:bla:jfinan:v:61:y:2006:i:6:p:2841-2897
    DOI: 10.1111/j.1540-6261.2006.01006.x
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