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Model Uncertainty and Option Markets with Heterogeneous Beliefs

Authors


  • Andrea Buraschi is at Tanaka Business School, Imperial College, London. Alexei Jiltsov is at Lehman Brother, London. We would like to thank Gurdip Bakshi, Suleyman Basak, Francisco Gomes, Dennis Gromb, Randi Rosenblatt, Raman Uppal, Pietro Veronesi, an anonymous referee, and the editor (Robert Stambaugh) for helpful comments and seminar participants at Columbia Business School, London Business School, Stockholm School of Economics, Tanaka Business School London, University of Amsterdam, University of Maryland, University of Southern California, the Western Finance Association Conference, and the Gerzensee Symposium. The project was supported by an ESRC Research Grant #R000223628. The usual disclaimer applies.

ABSTRACT

This paper provides option pricing and volume implications for an economy with heterogeneous agents who face model uncertainty and have different beliefs on expected returns. Market incompleteness makes options nonredundant, 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 S&P500 index option data. Specifically, we use survey data to build an Index of Dispersion in Beliefs and find that a model that takes information heterogeneity into account can explain the dynamics of option volume and the smile better than can reduced-form models with stochastic volatility.

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