Behavioral Finance Approach to European Option Pricing

This paper provides a further insight on how behavioral prospect theory may be incorporated into European option pricing framework. According to the prospect theory, decisions of agents are usually based on the potential values of gains and losses rather than based on expected utility of outcomes. The theory introduces a concept of value function, which is related to assessing gains and losses, and probability weighting function, which is associated with decision weights. Prospect theory may be incorporated into European option pricing framework. It was done by several studies. These studies show that behavioral models of option pricing perform better than Black-Scholes and Heston stochastic volatility models. This paper performs an empirical test on which probability weighting function can better explain option market data, using one of the behavioral option pricing models. Specifically, Quiggin's (1982) and Prelec's (1998) probability weighting functional forms are tested. For the empirical test, S&P 500 index European call options for a 3-month period are used. The results suggest that there is no significant difference between weighting probability functions in terms of quality of fitting the market data on option prices. In other words, both weighting functions may be used for European call option pricing.