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Who Buys and Who Sells Options: The Role and Pricing of Options in an Economy with Background Risk

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  • Marti G. Subrahmanyam
  • Günter Franke
  • Richard C. Stapleton
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    Abstract

    In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their risk-taking behavior in the model. We show that investors with low or no background risk have a concave sharing rule, i.e., they sell options on the market portfolio, whereas investors with high background risk have a convex sharing rule and buy these options.

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    Bibliographic Info

    Paper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 98-063.

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    Date of creation: Feb 1998
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    Handle: RePEc:fth:nystfi:98-063

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    Postal: U.S.A.; New York University, Leonard N. Stern School of Business, Department of Economics . 44 West 4th Street. New York, New York 10012-1126
    Phone: (212) 998-0100
    Web page: http://w4.stern.nyu.edu/finance/
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    Cited by:
    1. Franke, Günter & Weber, Martin, 2003. "Heterogeneity of Investors and Asset Pricing in a Risk-Value World," CEPR Discussion Papers 3832, C.E.P.R. Discussion Papers.
    2. Philippe Bertrand & Jean-luc Prigent, 2014. "Equilibrium of Financial Derivative Markets under Portfolio Insurance Constraints," Working Papers 2014-330, Department of Research, Ipag Business School.
    3. Franke, Guenter & Schlesinger, Harris & Stapleton, Richard C., 2011. "Risk taking with additive and multiplicative background risks," Journal of Economic Theory, Elsevier, vol. 146(4), pages 1547-1568, July.
    4. Bakshi, Gurdip & Madan, Dilip & Panayotov, George, 2010. "Returns of claims on the upside and the viability of U-shaped pricing kernels," Journal of Financial Economics, Elsevier, vol. 97(1), pages 130-154, July.
    5. Adam, Tim, 2009. "Capital expenditures, financial constraints, and the use of options," Journal of Financial Economics, Elsevier, vol. 92(2), pages 238-251, May.
    6. Dana, Rose-Anne & Scarsini, Marco, 2007. "Optimal risk sharing with background risk," Journal of Economic Theory, Elsevier, vol. 133(1), pages 152-176, March.
    7. Hara, Chiaki & Huang, James & Kuzmics, Christoph, 2011. "Effects of background risks on cautiousness with an application to a portfolio choice problem," Journal of Economic Theory, Elsevier, vol. 146(1), pages 346-358, January.
    8. Das, Sanjiv R. & Statman, Meir, 2013. "Options and structured products in behavioral portfolios," Journal of Economic Dynamics and Control, Elsevier, vol. 37(1), pages 137-153.
    9. Adam-Muller, Axel F. A., 2000. "Hedging price risk when real wealth matters," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 549-560, August.
    10. Benninga, Simon Z. & Oosterhof, Casper M., 2004. "Hedging with forwards and puts in complete and incomplete markets," Journal of Banking & Finance, Elsevier, vol. 28(1), pages 1-17, January.
    11. Adam, Tim Rene, 2002. "Risk management and the credit risk premium," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 243-269, March.

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