Anchoring Heuristic in Option Pricing

34 Pages Posted: 26 Mar 2015 Last revised: 19 May 2017

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: October 30, 2016

Abstract

A common reasoning process is to rely on an informative starting point which is somewhat incorrect and then attempt to adjust it appropriately. Evidence suggests that underlying stock volatility is such a starting point, which is scaled-up to estimate call option volatility. I adjust Black-Scholes, Heston, and Bates option pricing models for reliance on this starting point. Adjusted Black-Scholes explains implied-volatility skew and other puzzles. Adjusted Heston stochastic volatility model matches the same data better, does so at more plausible values, while generating a steep short term skew. Furthermore, two novel predictions are empirically tested and are strongly supported in the data.

Keywords: Anchoring, Implied Volatility Skew, Stochastic Volatility, Jump Diffusion, Covered Call Writing, Zero-Beta Straddle, Leverage Adjusted Option Returns, Behavioral Finance

JEL Classification: G13, G12, G02

Suggested Citation

Siddiqi, Hammad, Anchoring Heuristic in Option Pricing (October 30, 2016). Available at SSRN: https://ssrn.com/abstract=2584839 or http://dx.doi.org/10.2139/ssrn.2584839

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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