European Option Pricing with Constant Relative Sensitivity Probability Weighting Function

32 Pages Posted: 18 Dec 2014

See all articles by Martina Nardon

Martina Nardon

Ca Foscari University of Venice - Dipartimento di Economia

Paolo Pianca

Ca Foscari University of Venice - Dipartimento di Economia

Date Written: December 12, 2014

Abstract

We evaluate European financial options under continuous cumulative prospect theory. Within this framework, it is possible to model investors’ attitude toward risk, which may be one of the possible causes of mispricing. We focus on probability risk attitudes and consider alternative probability weighting functions. In particular, curvature of the weighting function models optimism and pessimism when one moves from extreme probabilities, whereas elevation can be interpreted as a measure of relative optimism. The constant relative sensitivity weighting function is the only one, amongst those in the literature, which is able to model separately curvature and elevation. We are interested in studying the effects of both these features on options prices.

Keywords: Behavioral finance, cumulative prospect theory, curvature, elevation, European option pricing

JEL Classification: C63, D81, G13

Suggested Citation

Nardon, Martina and Pianca, Paolo, European Option Pricing with Constant Relative Sensitivity Probability Weighting Function (December 12, 2014). University Ca' Foscari of Venice, Dept. of Economics Working Paper Series No. 25/WP/2014, Available at SSRN: https://ssrn.com/abstract=2539085 or http://dx.doi.org/10.2139/ssrn.2539085

Martina Nardon (Contact Author)

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy

Paolo Pianca

Ca Foscari University of Venice - Dipartimento di Economia ( email )

Cannaregio 873
Venice, 30121
Italy
+390412346915 (Phone)
+390415221756 (Fax)

HOME PAGE: www.dma.unive.it/~pianca

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