Option pricing with mixed lévy subordinated price process and implied probability weighting function

Abootaleb Shirvani, Yuan Hu, Svetlozar T. Rachev, Frank J. Fabozzi

Research output: Contribution to journalArticlepeer-review

Abstract

It is essential to incorporate the impact of investor behavior when modeling the dynamics of asset returns. In this article, we reconcile behavioral finance and rational finance by incorporating investor behavior within the framework of dynamic asset pricing theory. To include the views of investors, we employ the method of subordination that has been proposed in the literature by including business (intrinsic, market) time. We define a mixed Lévy subordinated model by adding a single subordinated Lévy process to the well-known log-normal model, resulting in a new log-price process. We apply the proposed models to study the behavioral finance notion of “greed and fear” disposition from the perspective of rational dynamic asset pricing theory. The greedy or fearful disposition of option traders is studied using the shape of the probability weighting function. We then derive the implied probability weighting function for the fear and greed deposition of option traders in comparison to spot traders. Our result shows the diminishing sensitivity of option traders. Diminishing sensitivity results in option traders overweighting the probability of big losses in comparison to spot traders.

Original languageEnglish
Article number102
JournalJournal of Derivatives
Volume28
Issue number2
DOIs
StatePublished - Dec 2020

Keywords

  • Derivatives, options

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