Behavioral Heterogeneity in the Option Market
28 Pages Posted: 4 Mar 2007 Last revised: 6 May 2016
Date Written: February 1, 2007
This paper develops and tests a heterogeneous agents model for the option market. Contrary to the common practice in the heterogeneous agents literature of modeling the level process, we introduce heterogeneity and switching in the variance process of the stock market. The market consists of two types of agents; fundamentalists are assumed to expect the conditional volatility to return to the unconditional volatility, while chartists respond solely on noise from the level process. Agents are able to switch between groups according to a multinomial logit switching mechanism. The model simplifies to a GARCH-type specification with time-varying parameters, which depend on the distribution of agents across types. Estimation results for index options on the German DAX30 reveal that different types of traders are also actively involved in trading volatility. Being the only unobserved variable in an option pricing model, volatility plays a pivotal role in the determination of the value of an option. Hence, we find evidence that observed option prices are the result of heterogeneity in expectations about future volatility.
Keywords: Heterogeneous Agents, Option Markets, Fundamentalists, Chartists
JEL Classification: G12
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