Prices and Volumes of Options: A Simple Theory of Risk Sharing When Markets are Incomplete

Abstract

We present a simple theory of business-cycle movements of option prices and volumes. This theory relies on time-varying heterogeneity between agents in their demand for insurance against aggregate risk. Formally, we build an infinite-horizon model where agents face an aggregate risk, but also different levels of idiosyncratic risk. We manage to characterize analytically a general equilibrium in which positive quantities of derivatives are traded. This allows us to explain the informational content of derivative volumes over the business cycle. We also carry out welfare analysis with respect to the introduction of options, which appears not to be Pareto-improving.

Keywords: Option Pricing, Open Interest, Incomplete Markets

JEL Classification: G1, G10, E44