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Price Discovery through Options

Author

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  • Semyon MALAMUD

    (Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute)

Abstract

How does private information get incorporated into option prices? To study this question, I develop a non-linear, noisy rational expectations equilibrium model with asymmetric information and a full menu of call and put options available for trading. The model allows for an arbitrary distribution of the underlying payoff and general trader preferences. All equilibrium prices and portfolios are obtained in closed form. Learning from option prices is characterized explicitly in terms of a novel object, the second derivative of the signal-to-noise ratio, whose sign determines whether particular shapes of option prices are "good news". I show that there is a major difference in equilibrium behaviour for constant absolute risk aversion (CARA) and non-CARA preferences due to feedback effects between wealth, price discovery, and private information: First, if informed traders have non-CARA preferences, strong-form efficiency is always obtained, independent of the amount of noise trading. Second, when informed traders have CARA preferences, the nature of equilibrium changes drastically with wealth effects of uninformed trading: If the latter have non-CARA preferences, weak-form efficiency fails and option prices are not sufficient to recover the information contained in the aggregate demand.

Suggested Citation

  • Semyon MALAMUD, 2014. "Price Discovery through Options," Swiss Finance Institute Research Paper Series 14-36, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1436
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    File URL: http://ssrn.com/abstract=2440677
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    Cited by:

    1. Georgy Chabakauri & Kathy Yuan & Konstantinos E Zachariadis, 2022. "Multi-asset Noisy Rational Expectations Equilibrium with Contingent Claims," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(5), pages 2445-2490.

    More about this item

    Keywords

    options; asymmetric information; learning; informational efficiency;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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