Index Option Returns from an Anchoring Perspective

Hammad, Siddiqi (2015): Index Option Returns from an Anchoring Perspective.

Abstract

Using leverage adjusted index option data, a novel prediction of the anchoring adjusted option pricing model is tested. The anchoring model is based on the idea that the risk of the underlying stock is used as a starting point that gets adjusted upwards to estimate call option risk. The anchoring heuristic implies that such adjustments are insufficient leading to underestimation of option risk. The prediction of the anchoring model is strongly supported in the data spanning nearly 26 years. Furthermore, the anchoring model is shown to be consistent with the key features observed in the data.

• Item Type: MPRA Paper
• Language: English
• Keywords: Anchoring, Option Pricing, Leverage Adjusted Returns, Option Mispricing, Behavioral Finance
• Subjects: G - Financial Economics > G0 - General > G02 - Behavioral Finance: Underlying Principles; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

Baker, M., Pan X., and Wurgler, J. (2012), “The Effect of Reference Point Prices on Mergers & Acquisitions”, Journal of Financial Economics, 106, No. 1, pp. 49-71.

Campbell, S. D., and Sharpe, S. A. (2009), “Anchoring bias in consensus forecast and its effect on market prices”, Journal of Financial and Quantitative Analysis, Vol. 44, pp. 369-90.

Cen L., Hilary F., and Wei, J. (2013), “The role of anchoring bias in the equity market: Evidence from analysts’ earnings forecasts and stock returns”, Journal of Financial and Quantitative Analysis, Vol. 48, Issue 1, pp. 47-76.

Constantinides, G. M., Jackwerth, J. C, and Savov A. (2013), “The Puzzles of Index Option Returns”, Review of Asset Pricing Studies, Advanced Access Published May 27, 2013.

Douglas, C., Engelberg, J., Parsons, C. A., Van Wesep, E. D. (2015), “Anchoring on credit spreads”. The Journal of Finance, doi:10.1111/jofi.12248

Epley, N., and Gilovich, T. (2006), “The anchoring-and-adjustment heuristic: Why the adjustments are insufficient”. Psychological Science, No. 4, pp. 311-318.

Furnham, A., Boo, H.C., 2011. “A literature review of the anchoring effect.” The Journal of Socio-Economics 40, 35-42. doi: 10.1016/j.socec.2010.10.008.

Hirshleifer, D. (2001), “Investor Psychology and Asset Pricing”, Journal of Finance, Vol. LVI, No, 4, pp. 1533-1597.

Johnson, J., Liu, S., and Shnytzer, A. (2009), “To what extent do investors in a financial market anchor their judgment? Evidence from the Hong Kong horse-race betting market”, Journal of Behavioral Decision Making, Vol. 24, No. 2, pp. 410-434.

Kahneman, D., and Tversky, A. (1974), “Judgment under uncertainty: Heuristics in biases”. Science, Vol. 185, No. 4157, pp. 1124-1131.

Kaustia, Markku and Alho, Eeva and Puttonen, Vesa, How Much Does Expertise Reduce Behavioral Biases? The Case of Anchoring Effects in Stock Return Estimates. Financial Management, Vol. 37, No. 3, pp. 391-411, Autumn 2008. Available at SSRN: http://ssrn.com/abstract=1066641

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.

Shefrin, H. and Statman, M. (1994), “Behavioral Capital Asset Pricing Theory”, Journal of Financial and Quantitative Analysis, Vol. 29, Issue 3, pp. 323-349.

Shiller, Robert J., 1999. "Human behavior and the efficiency of the financial system," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 20, pages 1305-1340 Elsevier.

Siddiqi, H. (2015), “Anchoring Heuristic in Option Pricing”, May (2015). Available at SSRN: http://ssrn.com/abstract=2584839 or http://dx.doi.org/10.2139/ssrn.2584839

Siddiqi, H. (2012), “The Relevance of Thinking by Analogy for Investors’ Willingness to Pay: An Experimental Study”, Journal of Economic Psychology, Vol. 33, Issue 1, pp. 19-29.

Siddiqi, H. (2011), “Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment” IUP Journal of Behavioral Finance, Vol. VIII, No.2. pp. 58-69

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.