Adjusting Option Pricing Models for Informative Starting Points

35 Pages Posted: 20 May 2017 Last revised: 17 Jul 2017

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: October 1, 2016

Abstract

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

Siddiqi, Hammad, Adjusting Option Pricing Models for Informative Starting Points (October 1, 2016). Available at SSRN: https://ssrn.com/abstract=2971013 or http://dx.doi.org/10.2139/ssrn.2971013

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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