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.
Cite this paper
Kang, S. (2017) A Simple Model to Explain Expensive Index Call Options. Theoretical Economics Letters, 7, 316-323. doi: 10.4236/tel.2017.73024.
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