Heterogeneity in Beliefs and Expensive Index Options

Abstract

The literature to date has documented that index options may be too expensive and frequently violate stochastic dominance bounds. This paper investigates heterogeneity in beliefs to explain the reason for this. A simple economic model reveals that when agents are sufficiently heterogeneous in their beliefs on the expected output and/or volatility, a call option may be overpriced from the perspective of the representative agent. Empirically, we investigate various proxies for heterogeneity in beliefs calculated from the Consumer Confidence Survey, the Survey of Professional Forecasters, the Institutional Brokers' Estimate System, and VIX option data, and document the evidence supporting our explanation.

Keywords: heterogeneity in beliefs, index option, stochastic dominance

JEL Classification: G12, G13