ABSTRACT Finance researchers have been
debating over whether index options are overpriced. Most debates have focused
on expensive out-of-the-money put options. However, the stochastic dominance
literature has argued that S & P 500 Index call options are frequently
overpriced in the sense that every rational agent can improve her expected
utility by writing these call options that violate the stochastic dominance
upper bound. Hence, expensive index call options are also an unsolved puzzle in
the finance literature. On the other hand, recent finance papers find that
market makers play an important role in the pricing of index options. In this
paper, I explore how constrained market makers interact with heterogeneity in
beliefs and index option prices. Specifically, I develop an equilibrium model
that accommodates previous empirical/theoretical results related to heterogeneity
in beliefs, limits or arbitrage, and the role of market makers. The incremental
findings from my model can be summarized as follows. First, even with the
presence of market makers, the stochastic dominance upper bound violation of
index call options occurs when heterogeneity in beliefs is sufficiently large.
This result is novel, insomuch as someone may argue that if heterogeneous
end-users share the risk themselves, heterogeneity in the presence of
constrained market makers may not lead to option mispricing. Second, as the
market maker is more constrained, the stochastic dominance upper bound
violation becomes more severe. This paper is related to and contributes to the
growing literature on the puzzle of index options. In addition, this paper complements
the literature on the role of market makers in index option markets and the
stochastic dominance literature.
Cite this paper
Kang, S. (2018) The Stochastic Dominance Violation of Index Call Options in the Presence of Market Makers. Theoretical Economics Letters, 8, 1614-1622. doi: 10.4236/tel.2018.89103.
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