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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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    File URL: https://mpra.ub.uni-muenchen.de/31316/1/MPRA_paper_31316.pdf
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    References listed on IDEAS

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    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. Amin, Kaushik I, 1993. " Jump Diffusion Option Valuation in Discrete Time," Journal of Finance, American Finance Association, vol. 48(5), pages 1833-1863, December.
    3. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
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    5. 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.
    6. Nicolas P. B. Bollen & Robert E. Whaley, 2004. "Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?," Journal of Finance, American Finance Association, vol. 59(2), pages 711-753, April.
    7. Lustig, Hanno & Verdelhan, Adrien, 2012. "Business cycle variation in the risk-return trade-off," Journal of Monetary Economics, Elsevier, vol. 59(S), pages 35-49.
    8. Jin-Chuan Duan, 1995. "The Garch Option Pricing Model," Mathematical Finance, Wiley Blackwell, vol. 5(1), pages 13-32.
    9. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
    10. Siddiqi, Hammad, 2009. "Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment," MPRA Paper 13515, University Library of Munich, Germany.
    11. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
    12. Hull, John C & White, Alan D, 1987. " The Pricing of Options on Assets with Stochastic Volatilities," Journal of Finance, American Finance Association, vol. 42(2), pages 281-300, June.
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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.

    More about this item

    Keywords

    Coarse Thinking; Option Pricing; Implied Volatility; Implied Volatility Skew; Systematic Risk; Investor Sentiment; 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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