Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment

Siddiqi, Hammad (2009): Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment.

Abstract

Mullainathan et al [Quarterly Journal of Economics, May 2008] present a model of coarse thinking or analogy based thinking. The essential idea behind coarse thinking is that people put situations into categories and the values assigned to attributes in a given situation are affected by the values of corresponding attributes in other co-categorized situations. We test this hypothesis in an experiment on financial options against the benchmark of arbitrage-free pricing. Firstly, we test whether a financial option is priced in analogy with its underlying stock (transference). Secondly, we test for whether variations in the analogy between a financial option and its underlying stock matter (framing). We find evidence in support of both transference and framing.

• Item Type: MPRA Paper
• Language: English
• Keywords: Coarse Thinking, Financial Options, Arbitrage-Free Pricing
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; C - Mathematical and Quantitative Methods > C9 - Design of Experiments > C91 - Laboratory, Individual Behavior

References

Babcock, L., & Loewenstein, G. (1997). “Explaining bargaining impasse: The role of self-serving biases”. Journal of Economic Perspectives, 11(1), 109–126.

Babcock, L., Wang, X., & Loewenstein, G. (1996). “Choosing the wrong pond: Social comparisons in negotiations that reflect a self-serving bias”. The Quarterly Journal of Economics, 111(1), 1–19.

Black, F., Scholes, M. (1973). “The pricing of options and corporate liabilities”. Journal of Political Economy 81(3): pp. 637-65

Bossaerts, P., Plott, C. (2004), “Basic Principles of Asset Pricing Theory: Evidence from Large Scale Experimental Financial Markets”. Review of Finance, 8, pp. 135-169.

Carpenter, G., Rashi G., & Nakamoto, K. (1994), “Meaningful Brands from Meaningless Differentiation: The Dependence on Irrelevant Attributes,” Journal of Marketing Research 31, pp. 339-350

Edelman, G. (1992), Bright Air, Brilliant Fire: On the Matter of the Mind, New York, NY: BasicBooks.

Hogarth, R. M., & Einhorn, H. J. (1992). “Order effects in belief updating: The belief-adjustment model”. Cognitive Psychology, 24.

Kahneman, D., & Frederick, S. (2002). “Representativeness revisited: Attribute substitution in intuitive judgment”. In T. Gilovich, D. Griffin, & D. Kahneman (Eds.), Heuristics and biases (pp. 49–81). New York: Cambridge University Press.

Kahneman, D., & Tversky, A. (1982), Judgment under Uncertainty: Heuristics and Biases, New York, NY: Cambridge University Press.

Kluger, B., & Wyatt, S. (2004). “Are judgment errors reflected in market prices and allocations? Experimental evidence based on the Monty Hall problem”. Journal of Finance, pp. 969–997.

Lakoff, G. (1987), Women, Fire, and Dangerous Things, Chicago, IL: The University of Chicago Press.

Mullainathan, S., Schwartzstein, J., & Shleifer, A. (2008) “Coarse Thinking and Persuasion”. The Quarterly Journal of Economics, Vol. 123, Issue 2 (05), pp. 577-619.

Rendleman, R. (2002), Applied Derivatives: Options, Futures, and Swaps. Wiley-Blackwell.

Rockenbach, B. (2004), “The Behavioral Relevance of Mental Accounting for the Pricing of Financial Options”. Journal of Economic Behavior and Organization, Vol. 53, pp. 513-527.

Siddiqi, H. (2008). “Is the Lure of Choice Reflected in Market Prices? Experimental Evidence based on the 4-Door Monty Hall Problem”. Journal of Economic Psychology (2008) doi:10.1016/j.joep.2008.07.004

Zaltman, G. (1997), “Rethinking Market Research: Putting People Back In,” Journal of Marketing Research 34, pp. 424-437