Overview

The previous chapter describes how sentiment can induce smile patterns in the implied volatility functions (IVF) associated with option prices. The present chapter is the first part of a two-part discussion about smile patterns in practice. The chapter is based on a study of index option prices done in late 1996. ^[1] The original intention of the study was to conduct an exploratory investigation into the connection between option smiles and sentiment. For present purposes, the study will serve to introduce a body of work to be discussed in the next chapter.

This chapter discusses the impact of irrational exuberance on smile patterns in the IVF for index options. An argument is advanced that index option smiles can be understood in terms of heterogeneous beliefs, in that pessimistic investors predominantly affect the prices of out-of-the-money puts, and optimistic investors predominantly affect the prices of out-of-the-money calls. Recall that Chapters 6 and 7 suggested that the beliefs of most professional investors exhibit gambler s fallacy, while the beliefs of most individual investors exhibit extrapolation bias.

The present chapter also suggests that prices as a whole appeared to permit arbitrage profits. Recall that the absence of pure arbitrage profits is the weakest form of market efficiency. In previous chapters, equilibrium was assumed to exclude the possibility of arbitrage profits. The present chapter presents evidence suggesting that because of price pressure and sentiment, the no-arbitrage condition may fail in practice. ^[2]