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Coarse thinking, implied volatility, and the valuation of call and put options

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  • Siddiqi, Hammad

Abstract

People think by analogies and comparisons. Such way of thinking, termed coarse thinking by Mullainathan et al [Quarterly Journal of Economics, May 2008] is intuitively very appealing. 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 option pricing formula is a generalization of the Black-Scholes formula. The new formula not only provides explanations for the implied volatility skew and term structure puzzles in equity index options but is also consistent with the observed negative relationship between contemporaneous equity price shocks and implied volatility.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23261.

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Date of creation: 10 Jan 2010
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Handle: RePEc:pra:mprapa:23261

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Keywords: Coarse Thinking; Option Pricing; Implied Volatility; Implied Volatility Skew; Implied Volatility Smile; Implied Volatility Term Structure;

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  1. Siddiqi, Hammad, 2009. "Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment," MPRA Paper 13515, University Library of Munich, Germany.
  2. Shleifer, Andrei & Mullainathan, Sendhil & Schwartzstein, Joshua, 2008. "Coarse Thinking and Persuasion," Scholarly Articles 11022284, Harvard University Department of Economics.
  3. Bossaerts, Peter & Plott, Charles R., 2000. "Basic Principles of Asset Pricing Theory: Evidence From Large-Scale Experimental Financial Markets," Working Papers, California Institute of Technology, Division of the Humanities and Social Sciences 1070, California Institute of Technology, Division of the Humanities and Social Sciences.
  4. Rockenbach, Bettina, 2004. "The behavioral relevance of mental accounting for the pricing of financial options," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 53(4), pages 513-527, April.
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