A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs

Journal of Management Science and Engineering, Forthcoming

Australian Centre for Financial Studies - Finsia Banking and Finance Conference 2010

27 Pages Posted: 12 Jul 2010 Last revised: 23 Sep 2016

See all articles by Xuezhong He

Xuezhong He

Xi'an Jiaotong-Liverpool University (XJTLU)

Lei Shi

Macquarie University; Financial Research Network (FIRN)

Date Written: September 22, 2016

Abstract

This paper provides a difference-in-opinions equilibrium framework for pricing asset and option in a multi-period binomial economy with heterogeneous beliefs. Agents agree to disagree about their beliefs on the probability and asset return in each state of nature. By constructing a consensus belief, we examine the impact of heterogeneous beliefs on market equilibrium. We show that agents’ wealth shares are expected to remain the same under the consensus belief, although they are expected to increase under their own beliefs. Also large disagreement leads to lower risk premium, while high disagreement on the future return in up state (down state) leads to lower (higher) risk-free rate and expected return for the risky asset. Furthermore, under the consensus belief, the implied volatility of the call options exhibits some observed patterns widely documented in option markets.

Keywords: asset prices; heterogeneous beliefs; binomial trees; options;

JEL Classification: G12, D84

Suggested Citation

He, Xue-Zhong 'Tony' and Shi, Lei, A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs (September 22, 2016). Journal of Management Science and Engineering, Forthcoming, Australian Centre for Financial Studies - Finsia Banking and Finance Conference 2010, Available at SSRN: https://ssrn.com/abstract=1638773 or http://dx.doi.org/10.2139/ssrn.1638773

Xue-Zhong 'Tony' He

Xi'an Jiaotong-Liverpool University (XJTLU) ( email )

111 Renai Road, SIP
, Lake Science and Education Innovation District
Suzhou, JiangSu province 215123
China

Lei Shi (Contact Author)

Macquarie University ( email )

New South Wales 2109
Australia
+612 98508478 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au