Coarse Thinking and Pricing a Financial Option

Siddiqi, Hammad (2009): Coarse Thinking and Pricing a Financial Option.

Abstract

Mullainathan et al [Quarterly Journal of Economics, May 2008] present a formalization of the concept of coarse thinking in the context of a model of persuasion. 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 derive a new option pricing formula based on the assumption that the market consists of coarse thinkers as well as rational investors. The new formula, called the behavioral Black-Scholes formula is a generalization of the Black-Scholes formula. The new formula provides an explanation for the implied volatility skew puzzle in index options. In contrast with the Black-Scholes model, the implied volatility backed-out from the behavioral Black-Scholes formula is a constant. This finding suggests that the volatility skew (smile) may be a reflection of coarse thinking. That is, the skew is seen if rational investors are assumed to exist when actual investors are heterogeneous; coarse thinkers and rational investors.

• Item Type: MPRA Paper
• Language: English
• Keywords: Coarse Thinking, Financial Options, Rational Pricing. Implied Volatility, Implied Volatility Skew, Implied Volatility Smile, Black-Scholes Model
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; D - Microeconomics > D0 - General > D00 - General

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