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The Effects of Curvature and Elevation of the Probability Weighting Function on Options Prices

In: Mathematical and Statistical Methods for Actuarial Sciences and Finance

Author

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  • Martina Nardon

    (Ca’ Foscari University of Venice, Department of Economics, Center for Quantitative Economics)

  • Paolo Pianca

    (Ca’ Foscari University of Venice, Department of Economics, Center for Quantitative Economics)

Abstract

We evaluate European financial options under continuous cumulative prospect theory. Within this framework, it is possible to model investors’ attitude toward risk, which may be one of the possible causes of pricing errors. We focus on probability risk attitudes and use alternative probability weighting functions. In particular, curvature of the weighting function models optimism and pessimism when one moves from extreme probabilities, whereas elevation can be interpreted as a measure of relative optimism. The constant relative sensitivity weighting function is the only one, amongst those in the literature, which is able to model separately curvature and elevation. We are interested in studying the effects of both these features on options prices.

Suggested Citation

  • Martina Nardon & Paolo Pianca, 2014. "The Effects of Curvature and Elevation of the Probability Weighting Function on Options Prices," Springer Books, in: Cira Perna & Marilena Sibillo (ed.), Mathematical and Statistical Methods for Actuarial Sciences and Finance, edition 127, pages 149-152, Springer.
    • Handle: RePEc:spr:sprchp:978-3-319-05014-0_35
    DOI: 10.1007/978-3-319-05014-0_35
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