On the Evaluation of Options on Lotteries: An Experimental Study

We present the results of a comparative experimental study of the evaluation of simple lotteries and call/put/insurance options on these lotteries. The main findings and conclusions are:

(a) The observed bidding patterns depend on the type of asset under evaluation. In particular, subject behavior when buying or selling a basic lottery seems much more cautious than their behavior when buying or selling options on that lottery.

(b) The observed bidding patterns also depend on subject positions with respect to the underlying asset. In particular, the bids for buying lotteries and options long are statistically uncorrelated with the bids for selling the same lotteries and options short.

(c) Subjects with extreme risk attitudes are more inclined to violate basic no-arbitrage conditions (like the call-put parity) when bidding for the different lotteries.

We demonstrate that it is difficult to reconcile the experimental evidence with mainstream theories on individual decision and choice (although we find strong support for prospect theory in some parts of the data). We conclude that the evaluation of options on lotteries is context-dependent and subtler than perceived by existing theories.