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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.

Suggested Citation

  • Siddiqi, Hammad, 2010. "Coarse thinking, implied volatility, and the valuation of call and put options," MPRA Paper 23261, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:23261
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    File URL: https://mpra.ub.uni-muenchen.de/23261/1/MPRA_paper_23261.pdf
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    References listed on IDEAS

    as
    1. Peter Bossaerts & Charles Plott, 2004. "Basic Principles of Asset Pricing Theory: Evidence from Large-Scale Experimental Financial Markets," Review of Finance, European Finance Association, vol. 8(2), pages 135-169.
    2. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2008. "Coarse Thinking and Persuasion," The Quarterly Journal of Economics, Oxford University Press, vol. 123(2), pages 577-619.
    3. 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.
    4. Siddiqi, Hammad, 2009. "Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment," MPRA Paper 13515, University Library of Munich, Germany.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

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

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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