Reconciling Behavioral Finance and Rational Finance

38 Pages Posted: 6 Apr 2020

See all articles by Abootaleb Shirvani

Abootaleb Shirvani

Texas Tech University - Department of Mathematics and Statistics

Frank J. Fabozzi

EDHEC Business School

Borjana Racheva-Iotova

FactSet Company

Date Written: March 10, 2020

Abstract

In this paper, 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.

Keywords: Rational Dynamic Asset Pricing Theory, Behavioral Finance, Prospect Theory Value Function, Probability Weighting Function, Mixed Subordinated Variance Gamma Process

JEL Classification: G12, G13, C02

Suggested Citation

Shirvani, Abootaleb and Fabozzi, Frank J. and Racheva-Iotova, Borjana, Reconciling Behavioral Finance and Rational Finance (March 10, 2020). Available at SSRN: https://ssrn.com/abstract=3552403 or http://dx.doi.org/10.2139/ssrn.3552403

Abootaleb Shirvani (Contact Author)

Texas Tech University - Department of Mathematics and Statistics ( email )

Lubbock, TX 79409-1042
United States

Frank J. Fabozzi

EDHEC Business School ( email )

France
215 598-8924 (Phone)

Borjana Racheva-Iotova

FactSet Company ( email )

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