International Finance Discussion Papers (IFDP)
June 1995
Options, Sunspots, and the Creation of Uncertainty
David Bowman and Jon Faust
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.
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