A Cumulative Prospect Theory Approach to Option Pricing

36 Pages Posted: 30 Nov 2010

See all articles by Cokki Versluis

Cokki Versluis

Independent

Thorsten Lehnert

University of Luxembourg

Christian C. P. Wolff

University of Luxembourg - Luxembourg School of Finance; Centre for Economic Policy Research (CEPR)

Date Written: November 29, 2010

Abstract

It is a well known from the empirical option pricing literature, that actual option prices show persistent and systematic deviations from theoretical values under standard pricing assumptions. While a substantial number of enhancements have been proposed, these approaches typically leave investor’s preferences towards risk unmodified. In this paper, we study option prices under cumulative prospect theory. We distinguish two prospect option pricing models, based on whether cash flows are either considered to be segregated or aggregated over time. A numerical example is provided to highlight the effect of different degrees of prospect behavior on option prices. In an empirical application to S&P 500 index options, our models are compared with benchmark models that are frequently used in the option pricing literature. Results suggest that our prospect option pricing models significantly improve the fitting performance over the Black-Scholes model and that especially the aggregated version’s performance is at least equivalent to the stochastic volatility model of Heston.

Keywords: Prospect Theory, Framing, Mental Accounting, Risk Attitude, Loss Aversion, Probability Perception, Weighting Function, Stochastic Volatility, Option Pricing

JEL Classification: D01, G11, G12

Suggested Citation

Versluis, Cokki and Lehnert, Thorsten and Wolff, Christian C. P., A Cumulative Prospect Theory Approach to Option Pricing (November 29, 2010). Available at SSRN: https://ssrn.com/abstract=1717015 or http://dx.doi.org/10.2139/ssrn.1717015

Thorsten Lehnert

University of Luxembourg ( email )

6, rue Coudenhove-Kalergi
Luxembourg, L-1359
Luxembourg

Christian C. P. Wolff

University of Luxembourg - Luxembourg School of Finance ( email )

4, rue Albert Borschette
Luxembourg, 1246
Luxembourg

HOME PAGE: http://www.lsf.lu

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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