Option Pricing Formula with Resource Scarcity in the Brain

27 Pages Posted: 29 Jan 2021

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: November 1, 2020

Abstract

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

Siddiqi, Hammad, Option Pricing Formula with Resource Scarcity in the Brain (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 ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

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

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