Anchoring Heuristic and Currency Options

Abstract

Based on experimental evidence, I adjust the standard currency option pricing models for the anchoring heuristic of Tversky and Kahneman (1974). Anchoring provides an explanation for the market practice of using risk-reversals as sentiment proxy. While generating currency smiles even with geometric Brownian motion, anchoring adds power to stochastic volatility and jump diffusion approaches. In particular, anchoring mitigates the difficulty that stochastic volatility models face in generating a steep short-term skew. Anchoring predicts that the slope of the smile is positively related to underlying currency sentiment, whereas curvature is positively related to dispersion in the sentiment. Empirical evidence supports these predictions.

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

JEL Classification: G13, G12, G11, G02