Option Pricing when Investors are (Only) Sufficiently Rational

40 Pages Posted: 29 Jan 2021 Last revised: 29 Jul 2021

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business and Creative Industries

Austin Murphy

Oakland University - School of Business Administration

Date Written: November 1, 2020

Abstract

This research adapts the Black-Scholes option pricing model that is widely used in practice to a world where investors only form sufficiently rational expectations (expectations that deviate from perfection without creating arbitrage opportunities). Within the no-arbitrage interval of market values that may exist in the presence of transaction costs, we utilize recent findings from the brain sciences to show that option prices will reflect the Black-Scholes formula but with the risk-free rate replaced with a higher rate. We measure the improvement that this modification brings by calibrating the adjusted Black-Scholes model with S&P 500 index options. We show that extending the brain-centric approach to models with stochastic volatility and jumps leads to the same modification: replace the risk-free rate with a higher rate.

Keywords: Option pricing, Black-Scholes Formula, Implied Volatility Skew, Zero-Beta-Straddle, Covered-Call, Brain-Centric Approach Leverage-Adjusted Returns, Heston SV Model, Bates SVJ Model

JEL Classification: G13, G12

Suggested Citation

Siddiqi, Hammad and Murphy, J. Austin, Option Pricing when Investors are (Only) Sufficiently Rational (November 1, 2020). Available at SSRN: https://ssrn.com/abstract=3745406 or http://dx.doi.org/10.2139/ssrn.3745406

Hammad Siddiqi (Contact Author)

University of the Sunshine Coast-School of Business and Creative Industries ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

HOME PAGE: http://www.usc.edu.au/staff-repository/dr-hammad-siddiqi

J. Austin Murphy

Oakland University - School of Business Administration ( email )

Varner Hall - Room 502
Rochester, MI 48309-4401
United States
248-370-2125 (Phone)
248-370-4275 (Fax)

Do you want regular updates from SSRN on Twitter?

Paper statistics

Downloads
33
Abstract Views
330
PlumX Metrics