TITLE:
A Simple Model to Explain Expensive Index Call Options
AUTHORS:
Sang Baum Kang
KEYWORDS:
Heterogeneity in Beliefs, Stochastic Dominance Upper Bound, Index Option, Call Option, Representative Agent
JOURNAL NAME:
Theoretical Economics Letters,
Vol.7 No.3,
March
16,
2017
ABSTRACT: According to the empirical finance literature,
S&P 500 Index call options frequently violate the stochastic dominance
upper bounds. In other words, index call options in the US are frequently
overpriced. I propose a theoretical model to explain the reason for this. A
simple economic model in this article reveals that when agents are sufficiently
heterogeneous, a call option may be overpriced from the perspective of the
representative agent. The key economic intuitions can be summarized as follows:
First, if agents are sufficiently heterogeneous, a bullish agent, who is hungry
for the “exposure” to a stock, may buy an
expensive call option from a constrained bearish agent. Second, even though a call option is fairly priced from the perspectives of heterogeneous
market participants, it may be overpriced from the perspective of the
representative agent. Assuming reasonable
parameters of heterogeneity, I find that a call option price violates the
representative agent’s stochastic dominance upper bound.