Mental Accounting: A Closed Form Alternative to the Black Scholes Model
31 Pages Posted: 5 Aug 2011 Last revised: 18 Feb 2014
Date Written: February 2014
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: Suggested Citation