Index Option Returns from an Anchoring Perspective

18 Pages Posted: 13 May 2014 Last revised: 30 Jun 2015

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: July 8, 2014

Abstract

Constantinides et al (2013) put forward a number of empirical findings regarding leverage adjusted S&P 500 index option returns. Their findings are puzzling in the context of the Black-Scholes-Merton Option Pricing Model and the Capital Asset Pricing Model. Experimental evidence as well as the opinions of experienced market professionals indicate that call options are valued in analogy with the underlying stock. In this article, the implications of such analogy making for option pricing are explored, and the resulting analogy based option pricing model is put forward. In a one period binomial setting, I show the conditions under which arbitrage profits cannot be made against the analogy makers ensuring their survival. I show that the analogy model is consistent with the empirical findings in Constantinides et al (2013). Furthermore, the analogy model generates the implied volatility skew. Two predictions of the analogy model are also empirically tested and are found to be strongly supported in the data.

Keywords: Option Pricing, Behavioral Finance, Analogy Making, Leverage Adjusted Return, Risk Premium, Implied Volatility Skew

JEL Classification: G13, G12

Suggested Citation

Siddiqi, Hammad, Index Option Returns from an Anchoring Perspective (July 8, 2014). Available at SSRN: https://ssrn.com/abstract=2435791 or http://dx.doi.org/10.2139/ssrn.2435791

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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