Who Buys and Who Sells Options: The Role and Pricing of Options in an Economy with Background Risk

Journal of Economic Theory, 1998

Posted: 20 May 1998

See all articles by Guenter Franke

Guenter Franke

University of Konstanz - Department of Economics

Richard C. Stapleton

University of Strathclyde - Department of Accounting and Finance

Marti G. Subrahmanyam

New York University (NYU) - Department of Finance

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Abstract

In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of utility functions. Rather, it is the degree to which agents face other, non hedgeable, background risks that determines their risk-taking behavior in the model. We show that investors with low or no background risk have a concave sharing rule, i.e., they sell options on the market portfolio, whereas investors with high background risk have a convex sharing rule and buy these options.

JEL Classification: G13

Suggested Citation

Franke, Guenter and Stapleton, Richard C. and Subrahmanyam, Marti G., Who Buys and Who Sells Options: The Role and Pricing of Options in an Economy with Background Risk. Journal of Economic Theory, 1998. Available at SSRN: https://ssrn.com/abstract=90348

Guenter Franke

University of Konstanz - Department of Economics ( email )

Fach 147
Konstanz, 78457
Germany
+49 7531 88 2545 (Phone)
+49 7531 88 3559 (Fax)

Richard C. Stapleton

University of Strathclyde - Department of Accounting and Finance ( email )

Curran Building
100 Cathedral Street
Glasgow G4 0LN
United Kingdom
+44 1524 381 172 (Phone)
+44 1524 846874 (Fax)

Marti G. Subrahmanyam (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

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