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Prospect theory: An application to European option pricing

Martina Nardon () and Paolo Pianca

No 2012:34, Working Papers from Department of Economics, University of Venice "Ca' Foscari"

Abstract: Empirical studies on quoted options highlight deviations from the theoretical model of Black and Scholes; this is due to different causes, such as assumptions regarding the price dynamics, markets frictions and investors' attitude toward risk. In this contribution, we focus on this latter issue and study how to value European options within the continuous cumulative prospect theory. According to prospect theory, individuals do not always take their decisions consistently with the maximization of expected utility. Decision makers have biased probability estimates; they tend to underweight high probabilities and overweight low probabilities. Risk attitude, loss aversion and subjective probabilities are described by two functions: a value function and a weighting function, respectively. In our analysis, we use alternative probability weighting functions. We consider the pricing problem both from the writer's and holder's perspective, obtaining an interval for the prices of call and put options.

Keywords: Behavioral Finance; Cumulative Prospect Theory; European Option Pricing. (search for similar items in EconPapers)
JEL-codes: C63 D81 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-upt
Date: 2012
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