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Thinking by analogy, systematic risk, and option prices

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  • Siddiqi, Hammad

Abstract

People tend to 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 develop a new option pricing model based on the idea that the market consists of coarse thinkers as well as rational investors when limits to arbitrage (transaction costs) prevent rational investors from profiting at the expense of coarse thinkers. The new formula, which is a closed form solution to the model, is a generalization of the Black-Scholes formula. The new formula potentially provides a unified explanation for various implied volatility puzzles.

Suggested Citation

  • Siddiqi, Hammad, 2011. "Thinking by analogy, systematic risk, and option prices," MPRA Paper 31316, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:31316
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    References listed on IDEAS

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    Cited by:

    1. Chunpeng Yang & Bin Gao & Jianlei Yang, 2016. "Option pricing model with sentiment," Review of Derivatives Research, Springer, vol. 19(2), pages 147-164, July.

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    More about this item

    Keywords

    Coarse Thinking; Option Pricing; Implied Volatility; Implied Volatility Skew; Systematic Risk; Investor Sentiment; Implied Volatility Term Structure;
    All these keywords.

    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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