Wanted: behavioural finance models

Behavioural finance is a hot topic among traders and risk managers at present. From stock market bubbles and crashes to pro-cyclicality in lending, there is an increasing awareness of investor over- and under-reaction to market information. In the Cutting Edge pages of Risk, the topic has made an appearance up to now mainly in the analysis of tail risk and rare events. The asset and derivatives pricing models that make up much of our technical pages seem to be a behavioural finance-free zone.

Some might argue that this isn’t quite true. After the October 1987 crash, a skew appeared in equity options markets implying a fear of a downside that efficient market theory said should already be factored into stock prices. Since then, skews and smiles have become more pronounced in other markets too. Pricing theory sought to incorporate this ‘behavioural’ feature in the form of smile models, but this was more of an attempt to calibrate the models to option prices rather than analyse