A Simple Model to Explain Expensive Index Call Options

Abstract

According to the empirical finance literature, S&P 500 Index call options frequently violate the stochastic dominance upper bounds. In other words, index call options in the US are frequently overpriced. I propose a theoretical model to explain the reason for this. A simple economic model in this article reveals that when agents are sufficiently heterogeneous, a call option may be overpriced from the perspective of the representative agent. The key economic intuitions can be summarized as follows: First, if agents are sufficiently heterogeneous, a bullish agent, who is hungry for the “exposure” to a stock, may buy an expensive call option from a constrained bearish agent. Second, even though a call option is fairly priced from the perspectives of heterogeneous market participants, it may be overpriced from the perspective of the representative agent. Assuming reasonable parameters of heterogeneity, I find that a call option price violates the representative agent’s stochastic dominance upper bound.