A Partial Equilibrium Model of Option Markets

This paper uses an asymptotically valid expansion to derive explicitly agent's individual demand schedules and then the equilibrium allocations in options. Agents derive financial and non-tradeable income over time; they can only partially offset the latter using bonds and stocks and the option increases their risk-spanning possibilities. However the option does not have to complete the market. The paper studies the interaction between demand/prices, analyzes the (necessary) conditions for trade and discusses the importance of heterogeneity. It also looks into the case in which there is only a spanning demand, but no risk-sharing demand in options and explains that teh financial innovation would then "fail," and discusses the conditions under which the option price is determined entirely by distributional characteristics.