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Coarse Thinking and Pricing a Financial Option

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  • Siddiqi, Hammad

Abstract

Mullainathan et al [Quarterly Journal of Economics, May 2008] present a formalization of the concept of coarse thinking in the context of a model of persuasion. The essential idea behind coarse thinking is that people put situations into categories and the values assigned to attributes in a given situation are affected by the values of corresponding attributes in other co-categorized situations. We derive a new option pricing formula based on the assumption that the market consists of coarse thinkers as well as rational investors. The new formula, called the behavioral Black-Scholes formula is a generalization of the Black-Scholes formula. The new formula provides an explanation for the implied volatility skew puzzle in index options. In contrast with the Black-Scholes model, the implied volatility backed-out from the behavioral Black-Scholes formula is a constant. This finding suggests that the volatility skew (smile) may be a reflection of coarse thinking. That is, the skew is seen if rational investors are assumed to exist when actual investors are heterogeneous; coarse thinkers and rational investors.

Suggested Citation

  • Siddiqi, Hammad, 2009. "Coarse Thinking and Pricing a Financial Option," MPRA Paper 21749, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:21749
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    References listed on IDEAS

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    1. Linda Babcock & George Loewenstein, 1997. "Explaining Bargaining Impasse: The Role of Self-Serving Biases," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 109-126, Winter.
    2. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2008. "Coarse Thinking and Persuasion," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 123(2), pages 577-619.
    3. repec:bla:jfinan:v:59:y:2004:i:3:p:969-998 is not listed on IDEAS
    4. Siddiqi, Hammad, 2009. "Is the lure of choice reflected in market prices? Experimental evidence based on the 4-door Monty Hall problem," Journal of Economic Psychology, Elsevier, vol. 30(2), pages 203-215, April.
    5. Rockenbach, Bettina, 2004. "The behavioral relevance of mental accounting for the pricing of financial options," Journal of Economic Behavior & Organization, Elsevier, vol. 53(4), pages 513-527, April.
    6. Linda Babcock & Xianghong Wang & George Loewenstein, 1996. "Choosing the Wrong Pond: Social Comparisons in Negotiations That Reflect a Self-Serving Bias," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 111(1), pages 1-19.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Coarse Thinking; Financial Options; Rational Pricing. Implied Volatility; Implied Volatility Skew; Implied Volatility Smile; Black-Scholes Model;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D00 - Microeconomics - - General - - - General

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