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

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  • Siddiqi, Hammad
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    Abstract

    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.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 50759.

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    Date of creation: 30 Aug 2013
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    Handle: RePEc:pra:mprapa:50759

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    Keywords: Mental Accounting; Analogy Making; Option Pricing; Behavioral Finance; Implied Volatility Skew; Black Scholes;

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