Binomial Tree Option Pricing Model Based On Prospect Theory And Mental Account

Binomial tree option pricing model was founded on rational man hypothesis. However, irrational investors play a significant role in the real option market. They exhibit risk-aversion on positive return and loss-aversion as well. Meanwhile, they establish different mental accounts for different investable asset. Their behavior mentioned above, to some extent, has an influence on the price of options, which was ignored by binomial tree option pricing model. Therefore, this paper makes use of prospect theory and mental account, which are both derived from behavioral finance theory, to modify binomial tree option pricing model.First of all, this paper introduces the development of the theory of behavioral finance and its impact on the classical finance theory. Then it explains prospect theory and mental account in depth to present an academic foundation for the modified model. According to the previous psychological experiment result, investors intend to put options and stocks in one mental account and the bond in the other. Based on the principle that different assets yield the same return in one mental account, the paper employs value function and weighting function in the binomial tree option pricing model and deduces the price of European call option underlying stock.In the empirical test process, the paper chooses 50 European call options traded on the Chicago Board Options Exchange with the same expiration date to evaluate some key parameters. Then the paper calculates other options'price with the modified model and traditional binomial model respectively to verify the new model's ability in explaining the price on the market. Furthermore, the modified model is able to make an explanation to the financial anomaly- option smile. Last but not the least, the paper employs the model to research Chinese warrant market and compares the result with American option market. The result indicates that the investors in Chinese warrant market exhibit a strong irrational characteristic.