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Coarse Thinking and Pricing a Financial Option

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  • Siddiqi, Hammad

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.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 21749.

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Date of creation: 30 Dec 2009
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Handle: RePEc:pra:mprapa:21749

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Keywords: Coarse Thinking; Financial Options; Rational Pricing. Implied Volatility; Implied Volatility Skew; Implied Volatility Smile; Black-Scholes Model;

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  1. Babcock, Linda & Wang, Xianghong & Lowenstein, George, 1996. "Choosing the Wrong Pond: Social Comparisons in Negotiations That Reflect a Self-Serving Bias," The Quarterly Journal of Economics, MIT Press, vol. 111(1), pages 1-19, February.
  2. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2008. "Coarse Thinking and Persuasion," The Quarterly Journal of Economics, MIT Press, vol. 123(2), pages 577-619, 05.
  3. Linda Babcock & George Loewenstein, 1997. "Explaining Bargaining Impasse: The Role of Self-Serving Biases," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 109-126, Winter.
  4. Siddiqi, Hammad, 2009. "Is the lure of choice reflected in market prices? Experimental evidence based on the 4-door Monty Hall problem," Journal of Economic Psychology, Elsevier, vol. 30(2), pages 203-215, April.
  5. Rockenbach, Bettina, 2004. "The behavioral relevance of mental accounting for the pricing of financial options," Journal of Economic Behavior & Organization, Elsevier, vol. 53(4), pages 513-527, April.
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