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An anchoring-adjusted option pricing model is developed in which the expected return of the underlying stock is used as a starting point that gets adjusted upwards to form expectations about corresponding call option returns. Anchoring bias implies that such adjustments are insufficient. In continuous time, the anchoring price always lies within the bounds implied by expected utility maximization when there are proportional transaction costs. Hence, an expected utility maximizer may not gain utility by trading against the anchoring prone investors. The anchoring model is consistent with key features in option prices such as implied volatility skew, superior historical performance of covered call writing, inferior performance of zero-beta straddles, smaller than expected call option returns, and large magnitude negative put returns. The model is also consistent with the puzzling patterns in leverage adjusted option returns, and extends easily to jump-diffusion and stochastic-volatility approaches.

Keywords: Anchoring ; Implied Volatility Skew ; Covered Call Writing ; Zero-Beta Straddle ; Leverage Adjusted Option Returns ; Stochastic Volatility ; Jump Diffusion

Subject(s): Financial Economics

Issue Date: 2015-07

Publication Type: Working or Discussion Paper

PURL Identifier:

Total Pages: 37

JEL Codes: G13; G12; G02

Series Statement: Finance


Record appears in: University of Queensland > School of Economics > Risk and Sustainable Management Group Working Papers

Autor: Siddiqi, Hammad


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