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Valuation of Options in a Setting with Happiness-Augmented Preferences

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Author Info
Stephen Satchel (School of Finance and Economics, University of Technology, Sydney)
Vincenzo Merella (Birbeck College, University of London)

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Abstract

We derive a pricing formula for a European call option written on equity in a framework where returns and consumption covary with external happiness. Being a non-tradable variable, happiness is regarded as an extra variable in a parameterised version of state dependent utility. We derive an extended version of the Black-Scholes (BS) formula and find that, in an optimistic environment (that is, where a high growth rate of happiness is expected), the standard BS formula may underestimate the value of the call option, and overestimate its sensitivity to changes in the underlying parameters. Under the assumption of lognormality of the happiness distribution, testable hypotheses for quality of hedging strategies can also be implemented.

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File URL: http://www.business.uts.edu.au/qfrc/research/research_papers/rp182.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 182.

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Length: 23
Date of creation: 01 Aug 2006
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Handle: RePEc:uts:rpaper:182

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  1. Malcolm Baker & Jeffrey Wurgler, 2004. "Investor Sentiment and the Cross-Section of Stock Returns," NBER Working Papers 10449, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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