Coarse Thinking and Pricing a Financial Option

Hammad Siddiqi

MPRA Paper from University Library of Munich, Germany

Abstract: Mullainathan et al [Quarterly Journal of Economics, May 2008] present a formalization of the concept of coarse thinking in the context of a model of persuasion. The essential idea behind coarse thinking is that people put situations into categories and the values assigned to attributes in a given situation are affected by the values of corresponding attributes in other co-categorized situations. We derive a new option pricing formula based on the assumption that the market consists of coarse thinkers as well as rational investors. The new formula, called the behavioral Black-Scholes formula is a generalization of the Black-Scholes formula. The new formula provides an explanation for the implied volatility skew puzzle in index options. In contrast with the Black-Scholes model, the implied volatility backed-out from the behavioral Black-Scholes formula is a constant. This finding suggests that the volatility skew (smile) may be a reflection of coarse thinking. That is, the skew is seen if rational investors are assumed to exist when actual investors are heterogeneous; coarse thinkers and rational investors.

Keywords: Coarse Thinking; Financial Options; Rational Pricing. Implied Volatility; Implied Volatility Skew; Implied Volatility Smile; Black-Scholes Model (search for similar items in EconPapers)
JEL-codes: D00 G12 (search for similar items in EconPapers)
Date: 2009-12-30
New Economics Papers: this item is included in nep-cbe
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