Option Trading and Differences In Beliefs

Abstract

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 builds on the framework in Basak (2000). The model, calibrated to survey data predicts that: the di¤erence in beliefs can account for observed option trading volume; option trading volume is more likely to be driven by changes in di¤erence in beliefs than by wealth shocks; the open interest in options can proxy for di¤erence in beliefs; the model can partly explain the frequencies of violations of one-factor models reported by Bakshi, Cao, and Chen (2000). The model is ...tted to S&P 500 and LIFFE options prices and trading volumes, and series of option-implied di¤erence in beliefs (OIDB) are constructed. Studying the dynamics of OIDB we ...nd that (1) up to 30 percent in OIDB time variation can be explained by di¤erence 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. JEL classi...cation: D51, G12, G13.