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A Cumulative Prospect Theory Approach to Option Pricing

Author

Listed:
  • Christian Wolff

    (Luxembourg School of Finance, University of Luxembourg)

  • Thorsten Lehnert

    (Luxembourg School of Finance, University of Luxembourg)

  • Cokki Versluis

    (DSM Corporate Technology)

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.

Suggested Citation

  • Christian Wolff & Thorsten Lehnert & Cokki Versluis, 2009. "A Cumulative Prospect Theory Approach to Option Pricing," LSF Research Working Paper Series 09-03, Luxembourg School of Finance, University of Luxembourg.
    • Handle: RePEc:crf:wpaper:09-03
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    References listed on IDEAS

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    3. Svetlozar Rachev & Frank J. Fabozzi & Boryana Racheva-Iotova & Abootaleb Shirvani, 2017. "Option Pricing with Greed and Fear Factor: The Rational Finance Approach," Papers 1709.08134, arXiv.org, revised Mar 2020.
    4. Martina Nardon & Paolo Pianca, 2014. "European option pricing with constant relative sensitivity probability weighting function," Working Papers 2014:25, Department of Economics, University of Venice "Ca' Foscari".
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    More about this item

    Keywords

    Prospect Theory; Framing; Mental Accounting; Risk Attitude; Loss Aversion; Probability Perception; Weighting Function; Stochastic Volatility; Option Pricing.;
    All these keywords.

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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