Amsterdam Econometrics Seminars and Workshop Series

Paul Schneider (University of Lugano & Swiss Finance Institute, Switzerland)
Friday, 3 November 2017

This paper develops an equilibrium model of an options market, where a pessimist, an optimist, and a pragmatist trade option portfolios with each other. Incomplete markets allow them to form different opinions on the underlying distributions, while fundamental prices remain within bid ask bounds. An application of the model to S&P 500 options data shows that the agents use different and surprisingly small state spaces of the underlying.  The pessimist and the pragmatist sell variance swaps, commonly perceived to be an insurance instrument, rather than the optimist. Robustly to changes in the input parameters, the pessimist is the most successful agent, while the optimist quickly exits the economy. Belief dispersion predicts trading volume and open interest.