An Overreaction Implementation of the Coherent Market Hypothesis and Option Pricing
University of Tuebingen Discussion Paper No. 306
37 Pages Posted: 1 Jun 2006
Date Written: April 2006
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: Suggested Citation