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Behavioral Finance Option Pricing Formulas Consistent with Rational Dynamic Asset Pricing

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  • Svetlozar Rachev
  • Stoyan Stoyanov
  • Frank J. Fabozzi

Abstract

We derive behavioral finance option pricing formulas consistent with the rational dynamic asset pricing theory. In the existing behavioral finance option pricing formulas, the price process of the representative agent is not a semimartingale, which leads to arbitrage opportunities for the option seller. In the literature on behavioral finance option pricing it is allowed the option buyer and seller to have different views on the instantaneous mean return of the underlying price process, which leads to arbitrage opportunities according to Black (1972). We adjust the behavioral finance option pricing formulas to be consistent with the rational dynamic asset pricing theory, by introducing transaction costs on the velocity of trades which offset the gains from the arbitrage trades.

Suggested Citation

  • Svetlozar Rachev & Stoyan Stoyanov & Frank J. Fabozzi, 2017. "Behavioral Finance Option Pricing Formulas Consistent with Rational Dynamic Asset Pricing," Papers 1710.03205, arXiv.org.
    • Handle: RePEc:arx:papers:1710.03205
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    References listed on IDEAS

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