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Analogy Making, Option Prices, and Implied Volatility

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  • Siddiqi, Hammad

Abstract

We put forward a new option pricing formula based on the notion that people tend to think by analogies and comparisons. The new formula differs from the Black Scholes formula 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 an explanation for the implied volatility skew puzzle in equity options. We also discuss the key empirical predictions of the analogy formula.

Suggested Citation

  • Siddiqi, Hammad, 2013. "Analogy Making, Option Prices, and Implied Volatility," MPRA Paper 48862, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:48862
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    File URL: https://mpra.ub.uni-muenchen.de/48862/1/MPRA_paper_48862.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Analogy Making; Implied Volatility; Implied Volatility Skew; Option Prices; Risk Premium;

    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
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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