A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs
University of Technology Sydney (UTS) - School of Finance and Economics; Financial Research Network (FIRN)
University of Technology Sydney (UTS); Financial Research Network (FIRN)
September 22, 2016
Journal of Management Science and Engineering, Forthcoming
Australian Centre for Financial Studies - Finsia Banking and Finance Conference 2010
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.
Number of Pages in PDF File: 27
Keywords: asset prices; heterogeneous beliefs; binomial trees; options;
JEL Classification: G12, D84
Date posted: July 12, 2010 ; Last revised: September 23, 2016
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