What is it about?
We reply on starting points and attempt to make appropriate adjustments. However, our adjustments typically fall short. A useful and relevant starting point for the risk of a call option is the risk of the underlying stock. If risk of the underlying stock is used as a starting point and investors attempt to appropriately scale-it up to estimate the risk of a call option, then due to the anchoring-bias, risk of a call option is underestimated. Prices of both call and put options change. We derive adjusted formulas for both call and put options and find that several prominent option pricing anomalies including the implied volatility skew are explained.
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Why is it important?
A single idea and a small adjustment in option pricing formulas substantially improves their explanatory power. No other adjustment can explain such a variety of puzzling phenomena.
Perspectives
I see this research as building a bridge between cognitive science and finance. The world does not come to us as a series of unique events, rather we make sense of it within a framework of categories. A call option is a leveraged position in the underlying stock. So , a call option is placed in a sub-ordinate category or a category which is derived from the underlying stock. Such categorization clarifies the relationship between call and underlying payoffs; however, it confounds the relationship between call and underlying volatility. The implications of such confounding lead to various option pricing puzzles including the implied volatility skew.
Hammad Siddiqi
University of the Sunshine Coast
Read the Original
This page is a summary of: Anchoring-Adjusted Option Pricing Models, Journal of Behavioral Finance, January 2019, Taylor & Francis,
DOI: 10.1080/15427560.2018.1492922.
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