A Behavioural Approach to the Pricing of European Options

Abstract

Empirical studies on quoted options highlight deviations from the theoretical model of Black and Scholes; this is due to different causes, such as assumptions regarding the price dynamics, markets frictions and investors’ attitude toward risk. In this contribution, we focus on this latter issue and study how to value options within the continuous cumulative prospect theory. According to prospect theory, individuals do not always take their decisions consistently with the maximization of expected utility. Decision makers have biased probability estimates; they tend to underweight high probabilities and overweight low probabilities. Risk attitude, loss aversion and subjective probabilities are described by two functions: a value function and a weighting function, respectively. As in Versluis et al. [15], we evaluate European options; we consider the pricing problem both from the writer’s and holder’s perspective, and extend the model to the put option. We also use alternative probability weighting functions.