A Cumulative Prospect Theory Approach to Option Pricing

Christian Wolff, Thorsten Lehnert and Cokki Versluis ()
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Cokki Versluis: DSM Corporate Technology

LSF Research Working Paper Series from Luxembourg School of Finance, University of Luxembourg

Abstract: It is a well known empirical fact that actual option prices show persistent and systematic deviations from Black-Scholes option values. While a substantial number of enhancements have been proposed in the literature, these approaches typically leave investors’ preferences towards risk unmodified. In this paper we study option prices in an economy where investors are valuing call options according to the cumulative prospect theory of Kahneman and Tversky. We distinguish two prospect option pricing models, based on whether cash flows are either considered to be segregated or aggregated over time. These models are compared with the Black-Scholes model and the stochastic volatility model of Heston. Empirical analysis of European call options on the S&P 500 index shows that prospect option pricing models significantly improve the fitting performance compared with the Black-Scholes model and that especially the aggregated version’s performance is at least equivalent to the Heston model.

Keywords: Prospect Theory; Framing; Mental Accounting; Risk Attitude; Loss Aversion; Probability Perception; Weighting Function; Stochastic Volatility; Option Pricing. (search for similar items in EconPapers)
JEL-codes: D01 G11 G12 (search for similar items in EconPapers)
Date: 2009
New Economics Papers: this item is included in nep-cbe, nep-ore and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:crf:wpaper:09-03

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