Behavioral Option Pricing under Prospect Theory Framework and Heston Model

Behavioral option pricing has been one of the hottest frontiers in the area of international finance. Stochastic volatility model has become the de facto standard model of international derivatives pricing, but it is not accurate enough in the pricing of short-term options, especially for OTM. One of the reasons is that the traditional option pricing methods ignore the irrational psychological and behavioral factors in the real market. To solve this problem,prospect theory is brought into the traditional option pricing framework, the different value judgments of investors facing gains and losses are described by introducing the subjective value function, the subjective decision weight function is used to modify the probability density function of the asset price path described by Heston model, and then the cash flow in the two periods of signing and executing European option contracts is regarded as two separate mental accounts. Prices of European options under Heston model are derived under the condition of market equilibrium. The empirical results of SSE 50ETF option show that the Heston stochastic volatility model considering the prospect theory can significantly improve the pricing accuracy of short maturity OTM option. The model parameter correction results show that the improvement of pricing performance is due to the behavioral parameters representing irrational psychology and emotion included in Heston model. Relatively speaking, investors' risk attitude towards ITM options is nearly neutral, so the improvement of behavior parameters on its pricing accuracy is limited.