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Title:An overreaction implementation of the coherent market hypothesis and option pricing PDF Logo
Authors:Schöbel, Rainer
Veith, Jochen
Issue Date:2006
Series/Report no.:Tübinger Diskussionsbeitrag 306
Abstract:Inspired by the theory of social imitation (Weidlich 1970) and its adaptation to financial markets by the Coherent Market Hypothesis (Vaga 1990), we present a behavioral model of stock prices that supports the overreaction hypothesis. Using our dynamic stock price model, we develop a two factor general equilibrium model for pricing derivative securities. The two factors of our model are the stock price and a market polarization variable which determines the level of overreaction. We consider three kinds of market scenarios: Risk-neutral investors, representative Bernoulli investors and myopic Bernoulli investors. In case of the latter two, risk premia provide that herding as well as contrarian investor behaviour may be rationally explained and justified in equilibrium. Applying Monte Carlo methods, we examine the pricing of European call options. We show that option prices depend significantly on the level of overreaction, regardless of prevailing risk preferences: Downward overreaction leads to high option prices and upward overreaction results in low option prices.
Subjects:behavioral finance
coherent market hypothesis
market polarization
option pricing
overreaction
chaotic market
repelling market
JEL:G12
G13
Persistent Identifier of the first edition:urn:nbn:de:bsz:21-opus-22956
Document Type:Working Paper
Appears in Collections:Tübinger Diskussionsbeiträge, Universität Tübingen

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