Analogy Making and the Puzzles of Index Option Returns and Implied Volatility Skew
42 Pages Posted: 8 Jul 2014 Last revised: 1 Dec 2015
Date Written: November 2015
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: Option Pricing, Analogy Making, Leverage Adjusted Returns, Risk Premium, Implied Volatility Skew
JEL Classification: G13, G12
Suggested Citation: Suggested Citation