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Rev Fin 1996; 9:723-756
© 1996 the Society for Financial Studies

Article

Heterogeneous beliefs and the effect of replicatable options on asset prices

A Kraus1 and M Smith2
1 University of British Columbia, Canada
2 Prudential Mutual Funds Investment Management

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.


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