Probability Weighting and Heterogeneous Beliefs in Option Markets

• Applicant: Professor Dr. Maik Dierkes
• Subject Area: Accounting and Finance
• Term: from 2011 to 2013
• Project identifier: Deutsche Forschungsgemeinschaft (DFG) - Project number 210250112

Option markets facilitate the risk sharing in the economy as they allow the hedging of economic risks. Accordingly, their economic impact cannot be understated and a thorough understanding of the pricing mechanism in these markets is of tremendous value. Unfortunately, classical theory based on rational expectations and risk averse expected utility maximizers cannot explain observed option prices.The current project analyzes the possibility of probability weighting to explain observed option prices. Probability weighting is the unconsciously wrong evaluation of probabilities and allows for a better representation of real agents risk attitudes compared to the framework of expected utility theory.In addition to the analysis of competence effects on the aggregate market level, I explore whether individual investors prefer payoff profiles that are in line with the hypothesis of probability weighting, i.e. whether the hypothesis is supported by individual behavior on the micro level when it comes to portfolio choices. It is well known that heterogeneous beliefs can explain option prices. However, what determines the formation of these optimistic or pessimistic beliefs is hardly understood. This shortcoming establishes the second goal of the current project. In particular, we are looking at the formation of beliefs under frequent feedback from market prices to further investigate the apparent lack of learning by investor.After having separately analyzed the effects of probability weighting and heterogeneous beliefs, we consider a combination of both concepts. Presumably, this will help us understand aggregate risk aversion as well as the varying number of traders over time. Ultimately, this will give us a sense of how the risk sharing in the economy works.

• DFG Programme: Research Fellowships
• International Connection: Netherlands, USA
• Host: Professor Nicholas Barberis, Ph.D.