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Prospect theory: An application to European option pricing

Author

Listed:
  • Martina Nardon

    () (Department of Economics, University Of Venice C� Foscari)

  • Paolo Pianca

    (pianca@unive.it)

Abstract

Empirical studies on quoted options highlight deviations from the theoretical model of Black and Scholes; this is due to different causes, such as assumptions regarding the price dynamics, markets frictions and investors' attitude toward risk. In this contribution, we focus on this latter issue and study how to value European options within the continuous cumulative prospect theory. According to prospect theory, individuals do not always take their decisions consistently with the maximization of expected utility. Decision makers have biased probability estimates; they tend to underweight high probabilities and overweight low probabilities. Risk attitude, loss aversion and subjective probabilities are described by two functions: a value function and a weighting function, respectively. In our analysis, we use alternative probability weighting functions. We consider the pricing problem both from the writer's and holder's perspective, obtaining an interval for the prices of call and put options.

Suggested Citation

  • 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".
  • Handle: RePEc:ven:wpaper:2012:34
    as

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    References listed on IDEAS

    as
    1. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    2. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    3. Klaus Abbink & Bettina Rockenbach, 2006. "Option pricing by students and professional traders: a behavioural investigation," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 27(6), pages 497-510.
    4. Diecidue, Enrico & Schmidt, Ulrich & Zank, Horst, 2009. "Parametric weighting functions," Journal of Economic Theory, Elsevier, vol. 144(3), pages 1102-1118, May.
    5. Richard H. Thaler, 2008. "Mental Accounting and Consumer Choice," Marketing Science, INFORMS, vol. 27(1), pages 15-25, 01-02.
    6. Wakker,Peter P., 2010. "Prospect Theory," Cambridge Books, Cambridge University Press, number 9780521765015.
    7. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    8. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    9. Schmeidler, David, 1989. "Subjective Probability and Expected Utility without Additivity," Econometrica, Econometric Society, vol. 57(3), pages 571-587, May.
    10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    11. Hersh Shefrin & Meir Statman, 1993. "Behavioral Aspects of the Design and Marketing of Financial Products," Financial Management, Financial Management Association, vol. 22(2), Summer.
    12. 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.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Behavioral Finance; Cumulative Prospect Theory; European Option Pricing.;

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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