Behavioral Finance Option Pricing Formulas Consistent with Rational Dynamic Asset Pricing

Svetlozar Rachev, Stoyan Stoyanov and Frank Fabozzi (frank.fabozzi@edhec.edu)

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Abstract: We derive behavioral finance option pricing formulas consistent with the rational dynamic asset pricing theory. In the existing behavioral finance option pricing formulas, the price process of the representative agent is not a semimartingale, which leads to arbitrage opportunities for the option seller. In the literature on behavioral finance option pricing it is allowed the option buyer and seller to have different views on the instantaneous mean return of the underlying price process, which leads to arbitrage opportunities according to Black (1972). We adjust the behavioral finance option pricing formulas to be consistent with the rational dynamic asset pricing theory, by introducing transaction costs on the velocity of trades which offset the gains from the arbitrage trades.

Date: 2017-10
New Economics Papers: this item is included in nep-cfn, nep-cta and nep-fmk
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