RFS Advance Access originally published online on October 25, 2006
Review of Financial Studies 2008 21(6):2635-2676; doi:10.1093/rfs/hhl040
| ||||||||||||||||||||||||||||||||||||||||||||||||||
Information Quality and Options
Tuck School of Business, Dartmouth College
Send correspondence to Joel M. Vanden, Tuck School of Business, Dartmouth College, 100 Tuck Hall, Hanover, NH 03755. E-mail: joel.m.vanden{at}dartmouth.edu
JEL Classification: D8, G1
 |
Abstract |
|---|
Microstructure researchers have long understood that information quality has an effect on price formation in the underlying asset market. However, option researchers have largely ignored the fact that information quality might also impact the options market. This article characterizes the nature of the impact by showing how option prices and implied volatility levels are related to the forward looking information quality path. This result follows from a noisy rational expectations model that abandons the normal distribution in favor of the gamma distribution, but maintains the standard assumption of exponential utility. Thus the new model bridges the gap between the microstructure literature that relies so heavily on the normal-exponential framework, and the options literature that relies exclusively on models that are consistent with the limited liability of stock prices. The model's tractability allows for a robustness check against the standard framework and provides a viable setting for analyzing the empirical implications of information quality for the options market.
I thank Henry Cao, Roger Craine, Richard Green, Nils Hakansson, Mark Rubinstein, Matt Spiegel (the editor), and two anonymous referees for helpful comments. This paper is based on Chapter 3 of my dissertation at UC Berkeley. Research support from the Tuck School of Business, the Haas School at UC Berkeley, and the NASDAQ Educational Foundation is gratefully acknowledged. Any errors are mine.