Impact on Option Prices of Divergent Consumer Confidence

This paper investigates the impact on option prices of divergent consumer conÞdence. To model this, we assume that consumers disagree on the expected growth rate of aggregate consumption. With other conditions unchanged in the discrete-time Black-Scholes option-pricing model, we show that the representative consumer will have declining relative risk aversion instead of the assumed constant relative risk aversion. In this case all options will be underpriced by the Black-Scholes model under the assumption of bivariate lognormality. We also extend Benninga and Mayshar’s (2000) results about impact on option prices of heterogeneous beliefs and preferences to an N-agent economy. ∗The author is from the Department of Accounting and Finance, Lancaster University, UK. LA1 4YX. Tel: +(44) 1524 593633, Fax: +(44) 1524 847321, Email: [email protected]. He is grateful to Prof. Richard Stapleton for his guidence and encouragement. He would also like to thank Mr. Michael Mumford for his comments on the draft.