Abstract
We show that considering the human brain as resource-rational leads to simple yet powerful adjustments in option pricing formulas. For a European call option, the risk-free rate is replaced with a higher rate which increases with the risk-premium on the underlying stock. For a European put option, apart from the replacement of the risk-free rate with a higher rate, an extra additive term appears which increases with the risk-premium on the underlying. The adjusted prices, which remain within the rational option pricing bounds derived in the literature, generate implied volatility skew and provide a unified explanation for several option pricing puzzles. This suggests that misspecification in option pricing formulas is due to ignoring the optimal resource allocation mechanism in the brain.
Published Version
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