PT - JOURNAL ARTICLE
AU - Shirvani, Abootaleb
AU - Fabozzi, Frank J.
AU - Racheva-Iotova, Boryana
AU - Rachev, Svetlozar T.
TI - Option Pricing with Greed and Fear Factor: The Rational Finance Approach
AID - 10.3905/jod.2021.1.138
DP - 2021 Jul 20
TA - The Journal of Derivatives
PG - jod.2021.1.138
4099 - http://jod.pm-research.com/content/early/2021/07/20/jod.2021.1.138.short
4100 - http://jod.pm-research.com/content/early/2021/07/20/jod.2021.1.138.full
AB - In this article, we explain main concepts of prospect theory and cumulative prospect theory within the rational dynamic asset pricing framework. We derive option pricing formulas when asset returns are altered by a generalized prospect theory value function or a modified Prelec’s weighting probability function. We introduce new parametric classes for prospect theory value functions and probability weighting functions consistent with rational dynamic pricing theory. After the behavioral finance notion of “greed and fear” is studied from the perspective of rational dynamic asset pricing theory, we derive the corresponding option pricing formulas when asset returns follow continuous diffusions or discrete binomial trees. We define mixed subordinated variance gamma process to model asset return and derive the corresponding option pricing formula. Finally, we apply the proposed probability weighting functions to study the greedy or fearful disposition of option traders when asset returns follow a mixed subordinated variance gamma process. The results indicate availability bias and diminishing sensitivity of option traders.TOPICS: Quantitative methods, statistical methods, derivatives, options, portfolio management/multi-asset allocation, portfolio theoryKey Findings▪ The prospect theory value function is modified to make it consistent with rational dynamic asset pricing theory.▪ A new probability weighting function consistent with rational dynamic asset pricing theory and the corresponding option pricing formula are derived.▪ The new prospect theory value functions and probability weighting functions show possible extensions of the classical prospect theory and cumulative prospect theory.