Siddiqi, Hammad (2009): Coarse Thinking and Pricing a Financial Option.
Download (201kB) | Preview
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|
|Original Title:||Coarse Thinking and Pricing a Financial Option|
|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
|Depositing User:||Hammad Siddiqi|
|Date Deposited:||31 Mar 2010 06:01|
|Last Modified:||24 Jul 2016 17:36|
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. (2009). “Is the Lure of Choice Reflected in Market Prices? Experimental Evidence based on the 4-Door Monty Hall Problem”. Journal of Economic Psychology, April.
Zaltman, G. (1997), “Rethinking Market Research: Putting People Back In,” Journal of Marketing Research 34, pp. 424-437.