An Overreaction Implementation of the Coherent Market Hypothesis and Option Pricing

University of Tuebingen Discussion Paper No. 306

37 Pages Posted: 1 Jun 2006

See all articles by Rainer Schoebel

Rainer Schoebel

University of Tuebingen - Faculty of Economics and Social Sciences

Jochen Veith

University of Tuebingen - Faculty of Economics and Business Administration

Date Written: April 2006

Abstract

Inspired by the theory of social imitation (Weidlich 1970) and its adaptation to financial markets by the Coherent Market Hypothesis (Vaga 1990), we present a behavioral model of stock prices that supports the overreaction hypothesis. Using our dynamic stock price model, we develop a two factor general equilibrium model for pricing derivative securities. The two factors of our model are the stock price and a market polarization variable which determines the level of overreaction. We consider three kinds of market scenarios: Risk-neutral investors, representative Bernoulli investors and myopic Bernoulli investors. In case of the latter two, risk premia provide that herding as well as contrarian investor behaviour may be rationally explained and justified in equilibrium. Applying Monte Carlo methods, we examine the pricing of European call options. We show that option prices depend significantly on the level of overreaction, regardless of prevailing risk preferences: Downward overreaction leads to high option prices and upward overreaction results in low option prices.

Keywords: behavioral finance, coherent market hypothesis, market polarization, option pricing, overreaction, chaotic market, repelling market

JEL Classification: G12, G13

Suggested Citation

Schoebel, Rainer and Veith, Jochen, An Overreaction Implementation of the Coherent Market Hypothesis and Option Pricing (April 2006). University of Tuebingen Discussion Paper No. 306 . Available at SSRN: https://ssrn.com/abstract=904357 or http://dx.doi.org/10.2139/ssrn.904357

Rainer Schoebel (Contact Author)

University of Tuebingen - Faculty of Economics and Social Sciences ( email )

Mohlstrasse 36
D-72074 Tuebingen
Germany
+49 7071 2977088 (Phone)

Jochen Veith

University of Tuebingen - Faculty of Economics and Business Administration ( email )

Faculty of Economics and Business Administration
Mohlstrasse 36
Tuebingen, 72074
Germany
+49 7071 2977088 (Phone)

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