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Behavioralizing the Black-Scholes Model

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  • Siddiqi, Hammad

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.

Suggested Citation

  • Siddiqi, Hammad, 2015. "Behavioralizing the Black-Scholes Model," MPRA Paper 86234, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:86234
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    References listed on IDEAS

    as
    1. Leland, Hayne E, 1985. "Option Pricing and Replication with Transactions Costs," Journal of Finance, American Finance Association, vol. 40(5), pages 1283-1301, December.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Black-Scholes Model; Anchoring-and-Adjustment; Implied Volatility; Covered-Call; Zero-Beta Straddle; Leverage-Adjusted Returns;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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