The Effect of Options on Information Acquisition and Asset Pricing

Abstract

We study the eect of introducing an options market on investors’ incentive to collect private information in a rational expectation equilibrium model. We show that an options market has two eects on information acquisition: a negative eect, as options act as substitutes for information, and a positive eect, as informed investors have less need for options and can earn prots from selling them. When the population of informed investors is high because of the low information acquisition cost, the supply for options is larger than the demand, leading to low option prices. Low option prices in turn induce investors to use options instead of information to reduce risk, while informed investors have little opportunity to earn prots from selling options to cover their information acquisition cost. Introducing an options market thus decreases investors’ incentive to acquire information, and the prices of the underlying assets become less informative, leading to lower prices and higher volatilities. A dynamic extension of this analysis shows that introducing an options market increases the price reactions to earnings announcements. However, when the information acquisition cost is high, the opposite eects arise. Further analysis shows that our results are robust for more general derivatives. These results provide a potentially unied theory to reconcile the conicting empirical ndings on the options listing of individual stocks in both the U.S. market and international markets.