Coarse Thinking, Implied Volatility, and the Price of Call and Put Options

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 derive a new option pricing formula based on the idea that the market consists of coarse thinkers as well as rational investors when limits to arbitrage (transaction costs) stop rational investors from profiting at the expense of coarse thinkers. The new formula, called the behavioral option pricing formula is a generalization of the Black-Scholes formula. The new formula potentially provides a unified explanation for various implied volatility puzzles..

Number of Pages in PDF File: 31

Keywords: Coarse Thinking, Option Pricing, Implied Volatility, Implied Volatility Skew, Implied Volatility Smile, Implied Volatility Term Structure

JEL Classification: G13, G12

working papers series