WHO BUYS AND WHO SELLS OPTIONS : THE ROLE OF OPTIONS IN AN ECONOMY WITH BACKGROUND RISK
Abstract In this paper, we derive an equilibrium in which some investors buy call/put options on the market portfolio while others sell them. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their risk-taking behavior in the model. We show that investors with low or no background risk have a concave sharing rule, i.e., they sell options on the market portfolio, whereas investors with high background risk have a convex sharing rule and buy these options. Journal of Economic Literature Classification Numbers: D52, D81, G11, G13”