Model Uncertainty and Option Markets in Heterogeneous Economies

60 Pages Posted: 2 Mar 2005  

Andrea Buraschi

The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)

Alexei Jiltsov

London Business School; Lehman Brothers, New York

Date Written: February 2005

Abstract

This paper provides option pricing and volume implications for an incomplete market economy with heterogenous agents who face model uncertainty and disagree on the dividend growth rate. Market incompleteness makes options non-redundant while heterogeneity creates a link between differences in beliefs and option volumes. We solve for both option prices and volumes and test the joint empirical implications using SP500 index option data. We use survey data to build an Index of Dispersion in Beliefs and find that a model which takes into account information heterogeneity can explain the dynamics of option volume better than reduced-form models with stochastic volatility. Moreover, its hedging performance is superior. Finally, we find that the Index of Dispersion in Beliefs is correlated with changes in the shape of the smile and it forecasts future realized volatility even after controlling for the current implied volatility.

Keywords: Options, Heterogeneity, Beliefs, Trading Volume, Open Interest

JEL Classification: D51, G12, G13

Suggested Citation

Buraschi, Andrea and Jiltsov, Alexei, Model Uncertainty and Option Markets in Heterogeneous Economies (February 2005). Available at SSRN: https://ssrn.com/abstract=675974 or http://dx.doi.org/10.2139/ssrn.675974

Andrea Buraschi (Contact Author)

The University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
7738347123 (Phone)

HOME PAGE: http://www.andreaburaschi.com/

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.andreaburaschi.com/

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Alexei Jiltsov

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Lehman Brothers, New York ( email )

745 Seventh Avenue
New York, NY 10285
United States

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