European option pricing with constant relative sensitivity probability weighting function

Martina Nardon () and Paolo Pianca ()
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Paolo Pianca: Department of Economics, C� Foscari University Of Venice

No 2014:25, Working Papers from Department of Economics, University of Venice "Ca' Foscari"

Abstract: We evaluate European financial options under continuous cumulative prospect theory. Within this framework, it is possible to model investors� attitude toward risk, which may be one of the possible causes of mispricing. We focus on probability risk attitudes and consider alternative probability weighting functions. In particular, curvature of the weighting function models optimism and pessimism when one moves from extreme probabilities, whereas elevation can be interpreted as a measure of relative optimism. The constant relative sensitivity weighting function is the only one, amongst those in the literature, which is able to model separately curvature and elevation. We are interested in studying the effects of both these features on options prices.

Keywords: Behavioral finance; cumulative prospect theory; curvature; elevation; European option pricing. (search for similar items in EconPapers)
JEL-codes: C63 D81 G13 (search for similar items in EconPapers)
Pages: 32
Date: 2014
New Economics Papers: this item is included in nep-rmg
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