Options, Sunspots, and the Creation of Uncertainty
Abstract
We present a model in which the addition of an option market leads to sunspot equilibria in an economy which has no sunspot equilibrium before the market is introduced. This phenomenon occurs because the payoff of an option contract is contingent upon market prices, and while prices are taken as exogenous by individuals within the economy they are endogenous to the economy as a whole. Our results provide robust counterexamples to the two most prevalent views of options markets in finance. Following Ross [1976], it is often assumed that the addition of option contracts to an incomplete markets economy can help complete markets. We demonstrate that the addition of option markets can instead increase the number of events which agents need to insure against. Following Black-Scholes [1973], it is often assumed that the economy is such that options are redundant. We demonstrate equilibria in which an added option market is not redundant even when markets were complete before its introduction.
Abstract We present a model in which the addition ofan option market leads to sunspot eqt.ilibria in an economy which has no sunspot equilibrium before the market is int:~oduced. This phenomenon occurs because the payoff of an option contract is contingent upon market prices, and while prices are taken as exogenous by individuals within the economy they are endogenous to the economy as a whole. Our results provide robust counterexamples to the two most prevalent views of options markets in finance. Following Ross [1976], it is often assumed that the addition ofoption contracts to an incomplete markets economy can help complete markets. Wedemonstrate that the addition ofoption markets can instead increase the numberofevents which agents need to insure against. Following Black-Scholes [1973], it is often assumed that the economy is such that options are redundant. We demonstrate equilibriain which an added option market is not redundant even when markets were complete before its introduction.
Cite this document
David Bowman and Jon Faust (1995). Options, Sunspots, and the Creation of Uncertainty (IFDP 1995-510). Board of Governors of the Federal Reserve System, International Finance Discussion Papers. https://whenthefedspeaks.com/doc/ifdp_1995-510
@techreport{wtfs_ifdp_1995_510,
author = {David Bowman and Jon Faust},
title = {Options, Sunspots, and the Creation of Uncertainty},
type = {International Finance Discussion Papers},
number = {1995-510},
institution = {Board of Governors of the Federal Reserve System},
year = {1995},
url = {https://whenthefedspeaks.com/doc/ifdp_1995-510},
abstract = {We present a model in which the addition of an option market leads to sunspot equilibria in an economy which has no sunspot equilibrium before the market is introduced. This phenomenon occurs because the payoff of an option contract is contingent upon market prices, and while prices are taken as exogenous by individuals within the economy they are endogenous to the economy as a whole. Our results provide robust counterexamples to the two most prevalent views of options markets in finance. Following Ross [1976], it is often assumed that the addition of option contracts to an incomplete markets economy can help complete markets. We demonstrate that the addition of option markets can instead increase the number of events which agents need to insure against. Following Black-Scholes [1973], it is often assumed that the economy is such that options are redundant. We demonstrate equilibria in which an added option market is not redundant even when markets were complete before its introduction.},
}