The Effect of Options on Information Acquisition and Asset Pricing

48 Pages Posted: 29 Sep 2015

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: May 2015

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 due to low information acquisition cost, the supply for options is large, leading to low option prices. Low option prices in turn induce investors to use options instead of information to reduce risk, while informed investors earn little 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 (May 2015). Finance Down Under 2016 Building on the Best from the Cellars of Finance. Available at SSRN: https://ssrn.com/abstract=2666880 or http://dx.doi.org/10.2139/ssrn.2666880

Shiyang Huang (Contact Author)

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

Pokfulam Road
Hong Kong
China

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