A binomial model of asset and option pricing with heterogeneous beliefs

Xue-Zhong He, Lei Shi

Research output: Contribution to journalArticle

Abstract

This paper provides a difference-in-opinions equilibrium framework for pricing asset and option in a multi-period binomial economy with heterogeneous beliefs. Agents agree to disagree about their beliefs on the probability and asset return in each state of nature. By constructing a consensus belief, we examine the impact of heterogeneous beliefs on market equilibrium. We show that agents’ wealth shares are expected to remain the same under the consensus belief, although they are expected to increase under their own beliefs. Also large disagreement leads to lower risk premium, while high disagreement on the future return in up state (down state) leads to lower (higher) risk-free rate and expected return for the risky asset. Furthermore, under the consensus belief, the implied volatility of the call options exhibits some observed patterns widely documented in option markets.
Original languageEnglish
Pages (from-to)94-113
Number of pages20
JournalJournal of Management Science and Engineering
Volume1
Issue number1
DOIs
Publication statusPublished - Dec 2016
Externally publishedYes

Keywords

  • Asset prices
  • Heterogeneous beliefs
  • Binomial trees
  • Options

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