Abstract
Relying on a useful starting point and attempting to adjust it appropriately is a robust human decision-making heuristic. Evidence suggests that underlying stock volatility is such a starting point, which is scaled up to estimate call option volatility. The author adjusts the Black-Scholes, Heston, and Bates models for reliance on this starting point. The adjustment mechanism captures several option-return puzzles. The adjusted Black-Scholes generates implied-volatility skew. The adjusted Heston stochastic-volatility model matches the same data better, does so at more plausible parameter values, and generates a steep short-term skew. Furthermore, 2 novel predictions are empirically tested and strongly supported in the data.
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