Heterogeneous Beliefs and the Effect of Replicatable Options on Asset Prices

Alan Kraus and Maxwell Smith

The Review of Financial Studies, 1996, vol. 9, issue 3, 723-56

Abstract: We present two ways in which trading in a replicatable option can affect the price process of the underlying asset. in the first situation, trading an option that each investor views as pay-off redundant breaks a non-fully revealing equilibrium that exists when the option market is absent. The second situation involves a market that is dynamically complete without options, but in which introducing an option market allows self-confirming conjectures of additional uncertainty about the future price of the underlying asset. Heterogeneous beliefs play important though different roles in both situations. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Date: 1996
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