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A Cumulative Prospect Theory Approach to Option Pricing

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  • Christian Wolff

    ()
    (Luxembourg School of Finance, University of Luxembourg)

  • Thorsten Lehnert

    ()
    (Luxembourg School of Finance, University of Luxembourg)

  • Cokki Versluis

    ()
    (DSM Corporate Technology)

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    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.

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    Bibliographic Info

    Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 09-03.

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    Date of creation: 2009
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    Handle: RePEc:crf:wpaper:09-03

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    Related research

    Keywords: Prospect Theory; Framing; Mental Accounting; Risk Attitude; Loss Aversion; Probability Perception; Weighting Function; Stochastic Volatility; Option Pricing.;

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    Cited by:
    1. Martina Nardon & Paolo Pianca, 2012. "Prospect theory: An application to European option pricing," Working Papers 2012:34, Department of Economics, University of Venice "Ca' Foscari".

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