Analogy Making and the Structure of Implied Volatility Skew

41 Pages Posted: 17 Oct 2013 Last revised: 2 Dec 2015

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: November 2015

Abstract

An anchoring-adjusted option pricing model is developed in which the volatility of the underlying stock return is used as a starting point that gets adjusted upwards to form expectations about call option volatility. I show that the anchoring price lies within the bounds implied by risk-averse expected utility maximization when there are proportional transaction costs. The anchoring model provides a unified explanation for key option pricing puzzles. Two predictions of the anchoring model are empirically tested and found to be strongly supported with nearly 26 years of options data.

Keywords: Implied Volatility Skew, Implied Volatility, Stochastic Volatility, Jump Diffusion, Option Returns

JEL Classification: G13, G12

Suggested Citation

Siddiqi, Hammad, Analogy Making and the Structure of Implied Volatility Skew (November 2015). Available at SSRN: https://ssrn.com/abstract=2340903 or http://dx.doi.org/10.2139/ssrn.2340903

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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