Investors' Heterogeneity and Implied Volatility Smiles

Management Science, vol 59, pp 2392-2412.

41 Pages Posted: 23 Mar 2013 Last revised: 12 Feb 2014

See all articles by Tao Li

Tao Li

City University of Hong Kong (CityU) - Department of Economics & Finance

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2012

Abstract

Heterogeneity in beliefs and time preferences among investors make stock volatility stochastic, even though the volatility of the underlying dividend is constant. The prices of the European options written on this stock admit closed-form solutions, hence their hedging deltas. The Black-Scholes implied volatility surface, which depends on wealth distribution, investors' beliefs and time preferences, exhibits observed patterns that are widely documented in various options markets. Along with benchmark models, the model is calibrated weekly to the S&P 500 index options from January 1996 to April 2006. It shows comparable performance to the SVJ model and outperforms the traders' rules and two no-arbitrage models (SV and SVSI) in terms of out-of-sample pricing errors.

Keywords: Heterogeneous Beliefs, Option Pricing, Equilibrium Model, Volatility Smile, Heterogeneous Preferences

JEL Classification: G12, G13

Suggested Citation

Li, Tao, Investors' Heterogeneity and Implied Volatility Smiles (December 1, 2012). Management Science, vol 59, pp 2392-2412., Available at SSRN: https://ssrn.com/abstract=2237391

Tao Li (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

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