The Effects of Curvature and Elevation of the Probability Weighting Function on Options Prices

Martina Nardon () and Paolo Pianca ()
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Martina Nardon: Ca’ Foscari University of Venice, Department of Economics, Center for Quantitative Economics
Paolo Pianca: Ca’ Foscari University of Venice, Department of Economics, Center for Quantitative Economics

A chapter in Mathematical and Statistical Methods for Actuarial Sciences and Finance, 2014, pp 149-152 from Springer

Abstract: 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 pricing errors. We focus on probability risk attitudes and use 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: Cumulative prospect theory; Curvature; Elevation; European option pricing (search for similar items in EconPapers)
Date: 2014
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Persistent link: https://EconPapers.repec.org/RePEc:spr:sprchp:978-3-319-05014-0_35

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DOI: 10.1007/978-3-319-05014-0_35

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