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

PDF
MPRA_paper_21749.pdf Download (201kB)  Preview 
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 cocategorized 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 BlackScholes formula is a generalization of the BlackScholes formula. The new formula provides an explanation for the implied volatility skew puzzle in index options. In contrast with the BlackScholes model, the implied volatility backedout from the behavioral BlackScholes 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 

Original Title:  Coarse Thinking and Pricing a Financial Option 
Language:  English 
Keywords:  Coarse Thinking, Financial Options, Rational Pricing. Implied Volatility, Implied Volatility Skew, Implied Volatility Smile, BlackScholes Model 
Subjects:  G  Financial Economics > G1  General Financial Markets > G12  Asset Pricing ; Trading Volume ; Bond Interest Rates D  Microeconomics > D0  General > D00  General 
Item ID:  21749 
Depositing User:  Hammad Siddiqi 
Date Deposited:  31 Mar 2010 06:01 
Last Modified:  24 Jul 2016 17:36 
References:  Babcock, L., & Loewenstein, G. (1997). “Explaining bargaining impasse: The role of selfserving 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 selfserving 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. 63765 Bossaerts, P., Plott, C. (2004), “Basic Principles of Asset Pricing Theory: Evidence from Large Scale Experimental Financial Markets”. Review of Finance, 8, pp. 135169. Carpenter, G., Rashi G., & Nakamoto, K. (1994), “Meaningful Brands from Meaningless Differentiation: The Dependence on Irrelevant Attributes,” Journal of Marketing Research 31, pp. 339350 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 beliefadjustment 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. 577619. Rendleman, R. (2002), Applied Derivatives: Options, Futures, and Swaps. WileyBlackwell. Rockenbach, B. (2004), “The Behavioral Relevance of Mental Accounting for the Pricing of Financial Options”. Journal of Economic Behavior and Organization, Vol. 53, pp. 513527. Siddiqi, H. (2009). “Is the Lure of Choice Reflected in Market Prices? Experimental Evidence based on the 4Door Monty Hall Problem”. Journal of Economic Psychology, April. Zaltman, G. (1997), “Rethinking Market Research: Putting People Back In,” Journal of Marketing Research 34, pp. 424437. 
URI:  https://mpra.ub.unimuenchen.de/id/eprint/21749 