Mental Accounting: A Closed Form Alternative to the Black Scholes Model

31 Pages Posted: 5 Aug 2011 Last revised: 18 Feb 2014

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: February 2014

Abstract

Experimental and anecdotal evidence suggests that people rely on mental accounting while valuing a call option. I show that mental accounting generates a closed-form alternative to the Black Scholes formula that does not require a complete market. The new formula differs from the Black Scholes formula only 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 a new explanation for the implied volatility skew puzzle. The key empirical predictions of the analogy formula are discussed. Existing empirical evidence strongly supports these predictions.

Keywords: coarse thinking, option pricing, implied volatility, implied volatility skew, systematic risk, investor sentiment, implied volatility term structure

JEL Classification: G13, G12

Suggested Citation

Siddiqi, Hammad, Mental Accounting: A Closed Form Alternative to the Black Scholes Model (February 2014). Available at SSRN: https://ssrn.com/abstract=1905384 or http://dx.doi.org/10.2139/ssrn.1905384

Hammad Siddiqi (Contact Author)

University of the Sunshine Coast-School of Business ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

HOME PAGE: http://www.usc.edu.au/staff-repository/dr-hammad-siddiqi

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