Option Pricing when Investors are (Only) Sufficiently Rational
40 Pages Posted: 29 Jan 2021 Last revised: 29 Jul 2021
Date Written: November 1, 2020
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: Suggested Citation