Informative Starting Points and Option Prices
34 Pages Posted: 24 Apr 2017 Last revised: 30 Jul 2017
Date Written: October 30, 2016
In incomplete markets, risk judgments regarding options are necessary as options cannot be replicated by using the underlying stock and the risk-free asset. How are such risk judgments formed? Underlying stock risk is a natural starting point for call option risk as the two assets pay off in the same states, and call option volatility is a scaled-up version of the underlying stock volatility. However, using underlying stock risk as a starting point and attempting to scale-up appropriately exposes investors to anchoring bias, which lowers the risk-premium demanded on a call option. I show that anchoring-influenced option prices always lie within no-arbitrage bounds in incomplete markets. Modified versions of Black-Scholes, Heston, and Bates models are put forward. Modified models show improvements across several dimensions, while capturing several option-return puzzles. Two novel predictions arising from the modification are also empirically supported.
Keywords: Anchoring-And-Adjustment Heuristic, Implied Volatility Skew, Option Pricing Puzzles, Black-Scholes Model, Heston Model, Bates Model
JEL Classification: G13, G12, G02
Suggested Citation: Suggested Citation