A New Explanation for Call Option Overpricing: Theory and Empirical Evidence

Sang Baum Kang
2012 Social Science Research Network  
A recent empirical study (Constantinides et al, 2011) documents that S&P 500 Index call options are frequently over-priced in the sense that any rational agent can improve her expected utility by writing these calls. This article proposes a rational explanation for this puzzling finding. First, I theoretically show how heterogeneous beliefs on both expected return and volatility generate over-pricing of call options. Second, I propose a new methodology to empirically investigate the
more » ... ate the determinants of option over-pricing. Consistent with my explanation, this paper documents that the more dispersion in investors" beliefs there is, the more frequently options are over-priced. This result is robust to various implementations of the empirical study. JEL Classification: G12, G13
doi:10.2139/ssrn.2024254 fatcat:uf7xhdwe6rbsdelwbda4h7rcsm