Analogy Making and the Structure of Implied Volatility Skew
41 Pages Posted: 14 Jul 2014 Last revised: 2 Dec 2015
Date Written: March 1, 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: Implied Volatility Skew, Stochastic Volatility, Jump Diffusion, Covered Call Writing, Zero-Beta Straddle, Option Returns
JEL Classification: G13, G12
Suggested Citation: Suggested Citation