Abstract
What happens when the anchoring and adjustment heuristic of Tversky and Kahneman (1974) is incorporated in currency option models? Surprisingly, it generates the peculiar features of currency smiles within the Black-Scholes framework, while adding power to stochastic volatility and jump diffusion models. Anchoring versions converge to corresponding Black-Scholes, stochastic volatility, and jump diffusion models if adjustments to underlying currency risks to get to option risks are correct or if uncovered interest-rate parity holds. Anchoring predicts that the slope of the smile is positively related to recent spot trend, whereas curvature is positively related to diversity of sentiment. Empirical evidence supports these predictions.
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