Analogy Making In Complete and Incomplete Markets: A New Model for Pricing Contingent Claims

A key limitation of the Black Scholes model is that it assumes a complete market (claims are replicable with existing assets). We put forward a new option pricing formula that does not require market completeness. The new formula is based on the idea that people rely on, what can be termed, the principle of analogy making while valuing assets. The principle of analogy making says that similar assets should offer the same returns. This is in contrast with the principle of no arbitrage which says that identical assets should offer the same returns. Analogy making is consistent with experimental and anecdotal evidence. I show that the principle of analogy making is a special case of the coarse thinking model of Mullainathan, Schwartzstein, and Shleifer (2008). I then apply the coarse thinking/analogy making model to option pricing and put forward a new option pricing formula. The new formula differs from the Black Scholes formula due to the appearance of a parameter in the formula that captures the risk premium on the underlying. The new formula, called the analogy option pricing formula, provides an explanation for the implied volatility skew puzzle in equity options. The key empirical predictions of the analogy formula are also discussed.

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Working or Discussion Paper
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JEL Codes:
G13; G12
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 Record created 2017-04-01, last modified 2020-10-28

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