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European option pricing with constant relative sensitivity probability weighting function

Author

Listed:
  • Martina Nardon

    (Department of Economics, C� Foscari University Of Venice)

  • Paolo Pianca

    (Department of Economics, C� Foscari University Of Venice)

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.

Suggested Citation

  • Martina Nardon & Paolo Pianca, 2014. "European option pricing with constant relative sensitivity probability weighting function," Working Papers 2014:25, Department of Economics, University of Venice "Ca' Foscari".
    • Handle: RePEc:ven:wpaper:2014:25
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    More about this item

    Keywords

    Behavioral finance; cumulative prospect theory; curvature; elevation; European option pricing.;
    All these keywords.

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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