Risk-Neutral Option Valuation or Anchoring-and-Adjustment? Evidence from a Market Experiment

Hammad Siddiqi

Abstract


The standard approach to pricing an asset is to find an appropriate discount rate consistent with the cashflow risk and then apply it to derive a present value. Option pricing theory elegantly sidesteps the issue of discount-rate estimation by assuming that market participants can create a hypothetical risk-free portfolio consisting of an option and its underlying stock. Such a portfolio, being risk-free, is then discounted at the risk-free rate., and the option price is then recovered from the resulting present value. Given the practical difficulties in implementing this procedure including Knightian uncertainty about the true stochastic process of the underlying and market imperfections such as transaction costs, it has recently been proposed that market participants use the discount-rate of the underlying stock as an anchor and then attempt to adjust it appropriately to estimate the discount-rate of an option. We design a market experiment to distinguish between these two approaches and find strong support for the anchoring-and-adjustment mechanism.

Keywords: Anchoring-and-Adjustment Heuristic, Risk Neutral Option Valuation, Behavioral Finance, Option Pricing

JEL Classification: G40, G41, G13

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This work is licensed under a Creative Commons Attribution 4.0 International License.