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Who Buys and Who Sells Options: The Role and Pricing of Options in an Economy with Background Risk

Authors: Subrahmanyam, Marti G.
Franke, Günter
Stapleton, Richard C.
Issue Date: Feb-1998
Series/Report no.: FIN-98-063
Abstract: In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their risk-taking behavior in the model. We show that investors with low or no background risk have a concave sharing rule, i.e., they sell options on the market portfolio, whereas investors with high background risk have a convex sharing rule and buy these options.
Appears in Collections:Finance Working Papers

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