BFS 2002

Contributed Talk

This paper develops a general equilibrium economy in which options are not redundant and studies the impact of heterogeneity in beliefs on option prices and their trading volume. The model, calibrated to survey data predicts that: the difference in beliefs can account for observed option trading volume; option trading volume is more likely to be driven by changes in difference in beliefs than by wealth shocks; the open interest in options can proxy for difference in beliefs; the model can partly explain the frequencies of violations of one-factor models reported by (Bakshi, Cao and Cen 2000). The model is fitted to S&P 500 and LIFFE options prices and trading volumes, and series of option-implied difference in beliefs (OIDB) are constructed. Studying the dynamics of OIDB we find that (1) up to 30 percent in OIDB time variation can be explained by difference in beliefs implied by surveys (2) one standard deviation shock to OIDB increases the implied volatility by up to 120 basis points contemporaneously and increases the volatility smile slope by up to 10 basis points (3) option trading volume is more sensitive to shocks to OIDB than to shocks to the value of the underlying asset.