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A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs


Xuezhong He


University of Technology Sydney (UTS) - School of Finance and Economics

Lei Shi


University of Technology Sydney (UTS); Financial Research Network (FIRN)

July 12, 2010

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

Abstract:     
This paper provides a theoretical framework for pricing assets in a multi-period economy with heterogeneous beliefs. The stock price dynamics follow a binomial lattice structure. Agents are allowed to differ in their beliefs of 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. Statically, divergence of opinions leads to lower risk premium, greater divergence of opinions regarding future return in the upstate (downstate) leads to lower (higher) expected return for the risky asset and the risk-free rate. Dynamically, we show that the consensus belief is a fair belief to price options since agents’ wealth share process is a martingale under the consensus belief. Furthermore, call option prices exhibit implied volatility skew when the optimistic (pessimistic) agent is also confident (doubtful) about future asset returns.

Number of Pages in PDF File: 26

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

JEL Classification: G12, D84

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Date posted: July 12, 2010  

Suggested Citation

He, Xuezhong and Shi, Lei, A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs (July 12, 2010). Australian Centre for Financial Studies - Finsia Banking and Finance Conference 2010. Available at SSRN: http://ssrn.com/abstract=1638773 or http://dx.doi.org/10.2139/ssrn.1638773

Contact Information

Xue-Zhong 'Tony' He
University of Technology Sydney (UTS) - School of Finance and Economics ( email )
Haymarket
Sydney, NSW 2007
Australia
Lei Shi (Contact Author)
University of Technology Sydney (UTS) ( email )
Haymarket, Ultimo
PO Box 123
Sydney, NSW 2007
Australia
Financial Research Network (FIRN)
C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia
HOME PAGE: http://www.firn.org.au

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