Options and Expectations

Abstract:     
A great deal of attention has been paid to the pricing and hedging of options, but little to the question of who should buy them. Since options are in zero net supply, the average investor will never purchase (or sell) fairly-priced options. Thus investors holding options must differ from average. We focus on an investor with average risk preferences, but with expectations that differ from average. Using a binomial framework, it is shown that buyers who optimally purchase ordinary index options must believe the market is more mean-averting than the average investor; sellers believe the market is more mean-reverting. Buyers who optimally purchase exotic options must have equally exotic expectations about the market's stochastic behavior.

JEL Classification: G13

Accepted Paper Series