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Analogy Based Valuation of Currency Options

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  • Siddiqi, Hammad

Abstract

The two most intriguing anomalies in currency markets are: 1) the implied volatility smile in currency options, and 2) the forward discount bias in currency exchange rates. I show that if currency options are valued in analogy with the underlying currency and beliefs are heterogeneous, then the forward discount bias causes the smile. The analogy based currency option pricing formula is put forward, which converges to Garman-Kohlhagen formula if there is no forward discount bias. In the presence of the forward discount bias, an increase in belief dispersion increases the slope as well as the curvature of the smile.

Suggested Citation

  • Siddiqi, Hammad, 2015. "Analogy Based Valuation of Currency Options," MPRA Paper 62333, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:62333
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    References listed on IDEAS

    as
    1. Siddiqi, Hammad, 2014. "Analogy Making and the Structure of Implied Volatility Skew," MPRA Paper 60921, University Library of Munich, Germany.
    2. Beber, Alessandro & Breedon, Francis & Buraschi, Andrea, 2010. "Differences in beliefs and currency risk premiums," Journal of Financial Economics, Elsevier, vol. 98(3), pages 415-438, December.
    3. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128, Elsevier.
    4. Siddiqi, Hammad, 2012. "The relevance of thinking-by-analogy for investors’ willingness-to-pay: An experimental study," Journal of Economic Psychology, Elsevier, vol. 33(1), pages 19-29.
    5. Rötheli, Tobias F., 2010. "Causes of the financial crisis: Risk misperception, policy mistakes, and banks' bounded rationality," Journal of Behavioral and Experimental Economics (formerly The Journal of Socio-Economics), Elsevier, vol. 39(2), pages 119-126, April.
    6. Siddiqi, Hammad, 2009. "Is the lure of choice reflected in market prices? Experimental evidence based on the 4-door Monty Hall problem," Journal of Economic Psychology, Elsevier, vol. 30(2), pages 203-215, April.
    7. 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.
    8. Siddiqi, Hammad, 2015. "Analogy Based Valuation of Commodity Options," Risk and Sustainable Management Group Working Papers 197334, University of Queensland, School of Economics.
    9. 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.
    10. Siddiqi, Hammad, 2015. "Analogy based Valuation of Commodity Options," MPRA Paper 61083, University Library of Munich, Germany.
    11. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    12. Garman, Mark B. & Kohlhagen, Steven W., 1983. "Foreign currency option values," Journal of International Money and Finance, Elsevier, vol. 2(3), pages 231-237, December.
    13. Siddiqi, Hammad, 2009. "Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment," MPRA Paper 13515, University Library of Munich, Germany.
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    Cited by:

    1. Siddiqi, Hammad, 2015. "Relative Risk Perception and the Puzzle of Covered Call writing," MPRA Paper 62763, University Library of Munich, Germany.

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    More about this item

    Keywords

    Forward Discount Bias; Implied Volatility Smile; Analogy Making; Currency Options;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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