Option Pricing with Heterogeneous Expectations

Abstract

Abstract This paper re‐derives the finite mixture option pricing model of Ritchey (1990), based on the assumption that the option investors hold heterogeneous expectations about the parameters of the lognormal process of the underlying asset price. By proving that the model admits no riskless arbitrage, this paper justifies that the entire family of finite mixture of lognormal distributions is a desirable candidate set for recovering the risk‐neutral probability distributions from contemporaneous options quotes. The parametric method derived from the model is significantly simpler than the nonparametric method of Rubinstein (1994) for recovering the risk‐neutral probability distributions from contemporaneous option prices.