PT  - JOURNAL ARTICLE
AU  - Abootaleb Shirvani
AU  - Yuan Hu
AU  - Svetlozar T. Rachev
AU  - Frank J. Fabozzi
TI  - Option Pricing with Mixed Lévy Subordinated Price Process and Implied Probability Weighting Function
AID  - 10.3905/jod.2020.1.102
DP  - 2020 Apr 16
TA  - The Journal of Derivatives
PG  - jod.2020.1.102
4099  - https://pm-research.com/content/early/2020/04/16/jod.2020.1.102.short
4100  - https://pm-research.com/content/early/2020/04/16/jod.2020.1.102.full
AB  - It is essential to incorporate the impact of investor behavior when modeling the dynamics of asset returns. In this article, we reconcile behavioral finance and rational finance by incorporating investor behavior within the framework of dynamic asset pricing theory. To include the views of investors, we employ the method of subordination that has been proposed in the literature by including business (intrinsic, market) time. We define a mixed Lévy subordinated model by adding a single subordinated Lévy process to the well-known log-normal model, resulting in a new log-price process. We apply the proposed models to study the behavioral finance notion of “greed and fear” disposition from the perspective of rational dynamic asset pricing theory. The greedy or fearful disposition of option traders is studied using the shape of the probability weighting function. We then derive the implied probability weighting function for the fear and greed deposition of option traders in comparison to spot traders. Our result shows the diminishing sensitivity of option traders. Diminishing sensitivity results in option traders overweighting the probability of big losses in comparison to spot traders.TOPICS: Derivatives, optionsKey Findings• Behavioral finance and rational finance are reconciled by using a mixed Lévy subordinated process.• The mixed Lévy subordinated process develops a more realistic asset pricing model by incorporating the behavior and sentiment of investors in the log-return pricing model.• The implied probability weighting function under the mixed Lévy subordinated process model indicates the diminishing sensitivity of option traders.