Anchoring Heuristic and Currency Options

33 Pages Posted: 21 Mar 2016 Last revised: 4 Apr 2016

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: March 1, 2016

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

Suggested Citation

Siddiqi, Hammad, Anchoring Heuristic and Currency Options (March 1, 2016). Available at SSRN: https://ssrn.com/abstract=2752313 or http://dx.doi.org/10.2139/ssrn.2752313

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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