Heterogeneity and option pricing

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.