Behavioralizing the Black-Scholes Model

Siddiqi, Hammad (2015): Behavioralizing the Black-Scholes Model.

Abstract

In this article, I incorporate the anchoring-and-adjustment heuristic into the Black-Scholes option pricing framework, and show that this is equivalent to replacing the risk-free rate with a higher interest rate. I show that the price from such a behavioralized version of the Black-Scholes model generally lies within the no-arbitrage bounds when there are transaction costs. The behavioralized version explains several phenomena (implied volatility skew, countercyclical skew, skew steepening at shorter maturities, inferior zero-beta straddle return, and superior covered-call returns) which are anomalies in the traditional Black-Scholes framework. Six testable predictions of the behavioralized model are also put forward.

• Item Type: MPRA Paper
• Language: English
• Keywords: Black-Scholes Model, Anchoring-and-Adjustment, Implied Volatility, Covered-Call, Zero-Beta Straddle, Leverage-Adjusted Returns
• Subjects: G - Financial Economics > G0 - General > G00 - General; G - Financial Economics > G0 - General > G02 - Behavioral Finance: Underlying Principles; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General; G - Financial Economics > G2 - Financial Institutions and Services > G22 - Insurance ; Insurance Companies ; Actuarial Studies

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