Who Buys and Who Sells Options: The Role of Options in a General Equilibrium Model with Background Risk

Abstract

In this paper, we derive an equilibrium in which some investors buy call/put options on an asset while others sell them. Also, some investors supply and others demand forward contracts. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of the utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their hedging behavior in the model. For example, a privately- held firm exposed to foreign exchange risk may have profits which also depend on non-hedgeable risks in specific product markets. Our model suggests that the degree to which the firm will hedge the foreign exchange risk depends on the level of firm-specific risk to which it is subject. We show that investors with low or no background risk sell portfolio insurance, i.e., they sell options on the market portfolio, whereas investors with high background risk buy those options. A general increase in background risk in the economy reduces the forward price of the market portfolio. Also, the price of put options rises and the price of call options falls. However, in an economy with given background risk, all options will be overpriced if the option pricing model ignores the background risk.

JEL Classification: G13