RT Journal Article
SR Electronic
T1 Option Pricing with Mixed Lévy Subordinated Price Process and Implied Probability Weighting Function
JF The Journal of Derivatives
FD Institutional Investor Journals
SP jod.2020.1.102
DO 10.3905/jod.2020.1.102
A1 Abootaleb Shirvani
A1 Yuan Hu
A1 Svetlozar T. Rachev
A1 Frank J. Fabozzi
YR 2020
UL https://pm-research.com/content/early/2020/04/16/jod.2020.1.102.abstract
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.