Heterogeneous Beliefs, Public Information, and Option Markets
In an incomplete market setting with heterogeneous prior beliefs, I show that public information and strike price of option have substantial infl?uence on asset pricing in option markets, by investigating an absolute option pricing model with negative exponential utility investors and normally distributed dividend. I demonstrate that heterogeneous prior variances give rise to the economic value of option markets. In- vestors speculate in option market and public information improves allocational efficiency of markets only when there is heterogeneity in prior variance. Heterogeneity in mean is neither a necessary nor sufficient condition for generating speculations in op- tion markets. With heterogeneous beliefs, options are non-redundant assets which can facilitate side-betting and enable investors to take advantage of the disagreements and the differences in con?dence. This fact leads to a higher growth rate in the investors? certainty equivalents and, thus, a higher equilibrium interest rate. The public infor- mation system facilitates improved dynamic trading opportunities in option markets based on the heterogeneously updated posterior beliefs. With an intermediate signal precision and the option with intermediate strike price, the highest efficiency of side- betting is achieved, re?ected by a unique maximum point of the ex ante equilibrium interest rate. The public signal precision affects ex ante equilibrium risk premium only via its relationship with option.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Snehal Banerjee & Ilan Kremer, 2010. "Disagreement and Learning: Dynamic Patterns of Trade," Journal of Finance, American Finance Association, vol. 65(4), pages 1269-1302, 08.
- Morris, Stephen, 1995. "The Common Prior Assumption in Economic Theory," Economics and Philosophy, Cambridge University Press, vol. 11(02), pages 227-253, October.
- Hakansson, Nils H & Kunkel, J Gregory & Ohlson, James A, 1982.
" Sufficient and Necessary Conditions for Information to Have Social Value in Pure Exchange,"
Journal of Finance,
American Finance Association, vol. 37(5), pages 1169-81, December.
- Nils H. Hakansson & J. Gregory Kunkel & James A. Ohlson., 1981. "Sufficient and Necessary Conditions for Information to Have Social Value in Pure Exchange," Research Program in Finance Working Papers 122, University of California at Berkeley.
- Sugato Chakravarty & Huseyin Gulen & Stewart Mayhew, 2004. "Informed Trading in Stock and Option Markets," Journal of Finance, American Finance Association, vol. 59(3), pages 1235-1258, 06.
- David Easley & Maureen O'Hara & P.S. Srinivas, 1998. "Option Volume and Stock Prices: Evidence on Where Informed Traders Trade," Journal of Finance, American Finance Association, vol. 53(2), pages 431-465, 04.
- Brennan, Michael J. & Xia, Yihong, 2001. "Stock price volatility and equity premium," Journal of Monetary Economics, Elsevier, vol. 47(2), pages 249-283, April.
- Veronesi, Pietro, 1999. "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 975-1007.
- Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
- Joel M. Vanden, 2004. "Options Trading and the CAPM," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 207-238.
- H. Henry Cao & Hui Ou-Yang, 2009. "Differences of Opinion of Public Information and Speculative Trading in Stocks and Options," Review of Financial Studies, Society for Financial Studies, vol. 22(1), pages 299-335, January.
- Liu, Jun & Pan, Jun, 2003.
"Dynamic Derivative Strategies,"
4334-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
- 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.
- Milgrom, Paul & Stokey, Nancy, 1982.
"Information, trade and common knowledge,"
Journal of Economic Theory,
Elsevier, vol. 26(1), pages 17-27, February.
- Brennan, Michael J & Cao, H Henry, 1996. "Information, Trade, and Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 163-208.
- Richardson, Scott A. & Sloan, Richard G. & Soliman, Mark T. & Tuna, Irem, 2005. "Accrual reliability, earnings persistence and stock prices," Journal of Accounting and Economics, Elsevier, vol. 39(3), pages 437-485, September.
- Alexander David, 2008. "Heterogeneous Beliefs, Speculation, and the Equity Premium," Journal of Finance, American Finance Association, vol. 63(1), pages 41-83, 02.
When requesting a correction, please mention this item's handle: RePEc:aah:create:2012-23. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.