TABLE OF CONTENTS Sentiment measures the degree of bias in the representative investor s probability density function. Because options are naturally structured as contingent payoffs, they provide an important direct window into the sentiment function.
The present chapter develops a behavioral approach to option pricing. The discussion begins with some general characterization results, which are analogous to Theorem 20.1 for the term structure of interest rates. Several examples are presented in order to provide insight into the manner in which sentiment impacts the prices of options. Two of the examples illustrate how the Black Scholes formula, lying at the center of option pricing theory, extend to a behavioral setting.
Let Z be a security that pays Z( x t) in event x t. A European call option on Z that is issued at x t, has an exercise price of K, and expires on date t + ?, provides its holder with the right, but not the obligation, to purchase Z on date t + ? at price K. Assume that the holder of the call option is rational, and will exercise the call option if and only if the price of Z at t + ?, q Z( x t + ?), is at least K. Then the payoff function for the call option is max{ q Z( x t + ?) ? K, 0}.
A...
