Explaining the Smile in Currency Options: Is It Anchoring?

29 Pages Posted: 9 Apr 2015 Last revised: 21 Mar 2016

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: April 8, 2015

Abstract

What happens when the anchoring and adjustment heuristic of Tversky and Kahneman (1974) is incorporated in currency option models? Surprisingly, it generates the peculiar features of currency smiles within the Black-Scholes framework, while adding power to stochastic volatility and jump diffusion models. Anchoring versions converge to corresponding Black-Scholes, stochastic volatility, and jump diffusion models if adjustments to underlying currency risks to get to option risks are correct or if uncovered interest-rate parity holds. Anchoring predicts that the slope of the smile is positively related to recent spot trend, whereas curvature is positively related to diversity of sentiment. Empirical evidence supports these predictions.

Keywords: Anchoring, Currency Options, Black-Scholes, Stochastic Volatility, Jump Diffusion, Risk Reversals, Sentiment

JEL Classification: G13, G12, G02

Suggested Citation

Siddiqi, Hammad, Explaining the Smile in Currency Options: Is It Anchoring? (April 8, 2015). Available at SSRN: https://ssrn.com/abstract=2591794 or http://dx.doi.org/10.2139/ssrn.2591794

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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