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Prices and volumes of options: A simple theory of risk sharing when markets are incomplete

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  • Le Grand, F.
  • Ragot, X.

Abstract

We present a simple theory of business-cycle movements of option prices and volumes. This theory relies on time-varying heterogeneity between agents in their demand for insurance against aggregate risk. Formally, we build an infinite-horizon model where agents face an aggregate risk, but also different levels of idiosyncratic risk. We manage to characterize analytically a general equilibrium in which positive quantities of derivatives are traded. This allows us to explain the informational content of derivative volumes over the business cycle. We also carry out welfare analysis with respect to the introduction of options, which appears not to be Pareto-improving.

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Bibliographic Info

Paper provided by Banque de France in its series Working papers with number 302.

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Length: 42 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bfr:banfra:302

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Postal: Banque de France 31 Rue Croix des Petits Champs LABOLOG - 49-1404 75049 PARIS
Web page: http://www.banque-france.fr/
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Keywords: Option Pricing; Open Interest; Incomplete Markets.;

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  1. Toshihiko Mukoyama & Anthony A. Smith & Per Krusell, 2008. "Asset Prices in a Huggett Economy," 2008 Meeting Papers 181, Society for Economic Dynamics.
  2. Edouard Challe & François Le Grand & Xavier Ragot, 2007. "Incomplete markets, liquidation risk and the term structure of interest rates," PSE Working Papers halshs-00587679, HAL.
  3. Monique, W.M. Donders & Roy Kouwenberg & Ton, C. F. Vorst, 2000. "Options and earnings announcements: an empirical study of volatility, trading volume, open interest and liquidity," European Financial Management, European Financial Management Association, vol. 6(2), pages 149-171.
  4. Edouard Challe & François Le Grand & Xavier Ragot, 2007. "Incomplete markets, liquidation risk and the term structure of interest rates," Working Papers halshs-00587679, HAL.
  5. 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.
  6. Franke, Gunter & Stapleton, Richard C. & Subrahmanyam, Marti G., 1998. "Who Buys and Who Sells Options: The Role of Options in an Economy with Background Risk," Journal of Economic Theory, Elsevier, vol. 82(1), pages 89-109, September.
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