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This paper provides option pricing and volume implications for an economy with heterogeneous agents who face model uncertainty and have different beliefs on expected returns. Market incompleteness makes options nonredundant, while heterogeneity creates a link between differences in beliefs and option volumes. We solve for both option prices and volumes and test the joint empirical implications using S&P500 index option data. Specifically, we use survey data to build an Index of Dispersion in Beliefs and find that a model that takes information heterogeneity into account can explain the dynamics of option volume and the smile better than can reduced-form models with stochastic volatility. Copyright 2006 by The American Finance Association.

This paper introduces a new class of nonaffine models of the term structure of interest rates that is supported by an economy with habit formation. Distinguishing features of the model are that the interest rate dynamics are nonlinear, interest rates depend on lagged monetary and consumption shocks, and the price of risk is not a constant multiple of interest rate volatility. We find that habit persistence can help reproduce the nonlinearity of the spot rate process, the documented deviations from the expectations hypothesis, the persistence of the conditional volatility of interest rates, and the lead-lag relationship between interest rates and monetary aggregates. Copyright 2007 by The American Finance Association.