A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs

Xuezhong (Tony) He () and Lei Shi
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Lei Shi: Macquarie University

Published Paper Series from Finance Discipline Group, UTS Business School, University of Technology, Sydney

Abstract: This paper provides a difference-in-opinions equilibrium framework for pricing asset and option in a multi-period binomial economy with heterogeneous beliefs. Agents agree to disagree about their beliefs on the probability and asset return in each state of nature. By constructing a consensus belief, we examine the impact of heterogeneous beliefs on market equilibrium. We show that agents’ wealth shares are expected to remain the same under the consensus belief, although they are expected to increase under their own beliefs. Also large disagreement leads to lower risk premium, while high disagreement on the future return in up state (down state) leads to lower (higher) risk-free rate and expected return for the risky asset. Furthermore, under the consensus belief, the implied volatility of the call options exhibits some observed patterns widely documented in option markets.

Keywords: Asset prices; Heterogeneous beliefs; Binomial trees; Options (search for similar items in EconPapers)
JEL-codes: D84 G12 (search for similar items in EconPapers)
Pages: 20 pages
Date: 2016-01-01
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Citations: View citations in EconPapers (1)

Published in: He, X. and Shi, L., 2016, "A Binomial Model of Asset and Option Pricing with Heterogeneous Beliefs", Journal of Management Science and Engineering, 1(1), 94-113.

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