Price Discovery Through Options
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. I show that there is a major difference in equilibrium behaviour between models with constant absolute risk aversion (CARA) and non-CARA preferences due to wealth effects. First, if informed traders have non-CARA preferences, equilibrium is always fully revealing, independent of the amount of noise in the supply. Second, when informed traders have CARA preferences, but uninformed traders have non-CARA preferences, weak-form efficiency fails: For generic signal structures, there exists a range of price realizations for which asset prices are not sufficient to recover the information contained in the noisy aggregate demand.
Finance Seminars at Caltech are funded through the generous support of the Linde Institute and Stephen A. Ross.