Option Pricing Formula with Resource Scarcity in the Brain
27 Pages Posted: 29 Jan 2021
Date Written: November 1, 2020
We show that considering the human brain as resource-rational leads to simple yet powerful adjustments in option pricing formulas. For a European call option, the risk-free rate is replaced with a higher rate which increases with the risk-premium on the underlying stock. For a European put option, apart from the replacement of the risk-free rate with a higher rate, an extra additive term appears which increases with the risk-premium on the underlying. The adjusted prices, which remain within the rational option pricing bounds derived in the literature, generate implied volatility skew and provide a unified explanation for several option pricing puzzles. This suggests that misspecification in option pricing formulas is due to ignoring the optimal resource allocation mechanism in the brain.
Keywords: Option pricing, Black-Scholes Formula, Heston SV Model, Bates SVJ Model. Implied Volatility Skew, Zero-Beta-Straddle, Covered-Call, Leverage-Adjusted Returns
JEL Classification: G13, G12
Suggested Citation: Suggested Citation