Heterogeneity and option pricing

Simon Benninga*, Joram Mayshar

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

46 Scopus citations

Abstract

An economy with agents having constant yet heterogeneous degrees of relative risk aversion prices assets as though there were a single decreasing relative risk aversion "pricing representative" agent. The pricing kernel has fat tails, and option prices do not conform to the Black-Scholes formula. Implied volatility exhibits a "smile." Heterogeneity as the source of non-stationary pricing fits Rubenstein's (1994) interpretation of the "over-pricing" as an indication of "crash-o-phobia". Rubinstein's term suggests that those who hold out-of-the money put options have relatively high risk aversion (or relatively high subjective probability assessments of low market outcomes). The essence of this explanation is investor heterogeneity.

Original languageEnglish
Pages (from-to)7-27
Number of pages21
JournalReview of Derivatives Research
Volume4
Issue number1
DOIs
StatePublished - 2000

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