Behavioral Finance Option Pricing Formulas Consistent with Rational Dynamic Asset Pricing

TL;DR

This paper develops behavioral finance option pricing formulas that align with rational dynamic asset pricing theory by incorporating transaction costs to eliminate arbitrage opportunities caused by differing views on asset returns.

Contribution

It introduces a new approach to behavioral option pricing formulas that are consistent with rational asset pricing by accounting for transaction costs.

Findings

Formulas eliminate arbitrage opportunities in behavioral models

Incorporating transaction costs aligns behavioral models with rational theory

Provides a more realistic framework for behavioral option pricing

Abstract

We derive behavioral finance option pricing formulas consistent with the rational dynamic asset pricing theory. In the existing behavioral finance option pricing formulas, the price process of the representative agent is not a semimartingale, which leads to arbitrage opportunities for the option seller. In the literature on behavioral finance option pricing it is allowed the option buyer and seller to have different views on the instantaneous mean return of the underlying price process, which leads to arbitrage opportunities according to Black (1972). We adjust the behavioral finance option pricing formulas to be consistent with the rational dynamic asset pricing theory, by introducing transaction costs on the velocity of trades which offset the gains from the arbitrage trades.