Mental Accounting: A Closed-Form Alternative to the Black Scholes Model

The principle of no arbitrage says that identical assets should offer the same returns. However, experimental and anecdotal evidence suggests that people often rely on analogy making while valuing assets. The principle of analogy making says that similar assets should offer the same returns. I show that the principle of analogy making generates a closed-form alternative to the Black Scholes formula that does not require a complete market. The new formula differs from the Black Scholes formula only due to the appearance of a parameter in the formula that captures the risk premium on the underlying. The new formula,called the analogy option pricing formula, provides a new explanation for the implied volatility skew puzzle in equity options. The key empirical predictions of the analogy formula are discussed. Existing Empirical evidence strongly supports these predictions.