Options Markets, Self-Fulfilling Prophecies, and Implied Volatilities
Posted: 10 Sep 1999
Date Written: October 1994
Abstract
The Black-Scholes formula is the "industry standard" for pricing options on a variety of instruments. This paper shows that even when markets are incomplete, the Black- Scholes option pricing formula can arise in an equilibrium merely from self-fulfilling beliefs that it is the correct pricing formula. In such an equilibrium, the presence of traders speculating on the stock's underlying price movements can cause implied volatilities to deviate from future volatilities. This result provides a possible explanation for the recent empirical evidence supporting an "overreactions" effect in implied volatilities.
JEL Classification: G13, G14
Suggested Citation: Suggested Citation