Heterogeneous Beliefs, Public Information, and Option Markets

In an incomplete market setting with heterogeneous prior beliefs, I show that public information and strike price of option have substantial infl?uence on asset pricing in option markets, by investigating an absolute option pricing model with negative exponential utility investors and normally distributed dividend. I demonstrate that heterogeneous prior variances give rise to the economic value of option markets. In- vestors speculate in option market and public information improves allocational efficiency of markets only when there is heterogeneity in prior variance. Heterogeneity in mean is neither a necessary nor sufficient condition for generating speculations in op- tion markets. With heterogeneous beliefs, options are non-redundant assets which can facilitate side-betting and enable investors to take advantage of the disagreements and the differences in con?dence. This fact leads to a higher growth rate in the investors? certainty equivalents and, thus, a higher equilibrium interest rate. The public infor- mation system facilitates improved dynamic trading opportunities in option markets based on the heterogeneously updated posterior beliefs. With an intermediate signal precision and the option with intermediate strike price, the highest efficiency of side- betting is achieved, re?ected by a unique maximum point of the ex ante equilibrium interest rate. The public signal precision affects ex ante equilibrium risk premium only via its relationship with option.