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Price Discovery Across Options Using Arrow-Debreu and Kyle Models

Article arXiv papers · Author: Christian Keller et al.
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Summary

This document outlines an equilibrium model combining Arrow-Debreu state-contingent claims with Kyle-style informed trading. An informed trader has private information about the probabilities of future states and trades claims whose payoffs depend on those states. When those claims are options, the private information concerns the underlying asset’s payoff distribution, and the trader can express it through option portfolios.

The framework aims to explain established option-market practices and patterns, including common trading strategies and the volatility smile across strikes. The excerpt describes the model’s scope but gives no equations, calibration details, or empirical tests. Its claims should therefore be read as a summary of a proposed theoretical framework, rather than evidence that it predicts option prices or trading outcomes in practice.

Key ideas

  • The model combines state-contingent claims with informed trading in a Kyle-style equilibrium.
  • An informed trader may know the probabilities of future states and trade claims tied to those states.
  • In the options application, private information concerns the underlying asset’s payoff distribution.
  • The framework is intended to account for option trading practices and the volatility smile across strikes.

Tags

OptionsDerivatives pricingMarket microstructureVolatility
Full text
# Arrow-Debreu Meets Kyle: Price Discovery Across Derivatives


# Arrow-Debreu Meets Kyle: Price Discovery Across Derivatives









We study price discovery in a model where an informed agent has arbitrary private information about state probabilities and trades state-contingent claims. The model unifies the key elements of Arrow-Debreu (1954) and Kyle (1985). When the claims are options, the informed agent has arbitrary information about the underlying asset's payoff distribution and trades option portfolios. Our setting provides the first equilibrium framework that encompasses longs-tanding option-market practices and regularities, including common trading strategies and the volatility smile across strikes.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.