Option Pricing with Greed and Fear Factor: The Rational Finance Approach

Abstract: We explain the main concepts of Prospect Theory and Cumulative Prospect Theory within the framework of rational dynamic asset pricing theory. We derive option pricing formulas when asset returns are altered with a generalized Prospect Theory value function or a modified Prelec weighting probability function and introduce new parametric classes for Prospect Theory value functions and weighting probability functions consistent with rational dynamic pricing Theory. We study the behavioral finance notion of greed and fear from the point of view of rational dynamic asset pricing theory and derive the corresponding option pricing formulas in the case of asset returns that follow continuous diffusion or discrete binomial trees.