The Effect of Options on Information Acquisition and Asset Pricing

47 Pages Posted: 8 Oct 2014 Last revised: 7 Nov 2014

See all articles by Shiyang Huang

Shiyang Huang

The University of Hong Kong - Faculty of Business and Economics

Multiple version iconThere are 2 versions of this paper

Date Written: October 2014

Abstract

We study the effect of introducing an options market on investors' incentive to collect private information in a rational expectation equilibrium model. We show that an options market has two effects on information acquisition: a negative effect, as options act as substitutes for information, and a positive effect, as informed investors have less need for options and can earn profits from selling them. When the population of informed investors is high because of the low information acquisition cost, the supply for options is larger than the demand, leading to low option prices. Low option prices in turn induce investors to use options instead of information to reduce risk, while informed investors have little opportunity to earn profits from selling options to cover their information acquisition cost. Introducing an options market thus decreases investors' incentive to acquire information, and the prices of the underlying assets become less informative, leading to lower prices and higher volatilities. A dynamic extension of this analysis shows that introducing an options market increases the price reactions to earnings announcements. However, when the information acquisition cost is high, the opposite effects arise. Further analysis shows that our results are robust for more general derivatives. These results provide a potentially unified theory to reconcile the conflicting empirical findings on the options listing of individual stocks in both the U.S. market and international markets.

Keywords: Option, information acquisition cost, rational expectation equilibrium, derivatives

JEL Classification: G12, G13, G14

Suggested Citation

Huang, Shiyang, The Effect of Options on Information Acquisition and Asset Pricing (October 2014). Available at SSRN: https://ssrn.com/abstract=2506682 or http://dx.doi.org/10.2139/ssrn.2506682

Shiyang Huang (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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