| dc.description.abstract | The breakthrough Black-Scholes (BS) model predicts a horizontal line when plotting the implied volatility (IV) against the strike price. However, empirical studies uncovered that the implied volatility derived from option market prices in the BS model varies with strike prices and time to maturity, leading to the identification of three stylized facts that the BS model fails to explain. First, the IV curves exhibit a smile/smirk pattern, with an upward-sloping term structure for at-the-money options. Second, option prices tend to reflect higher implied volatility compared to the realized volatility of asset returns. Third, the negative skewness implied by options prices is greater in absolute terms compared with the realized skewness. Consequently, numerous sophisticated models have been developed to address these stylized facts. Nevertheless, traditional models often fall short of fully explaining all aspects of these phenomena. This study introduces a novel approach to the utility indifference model by incorporating behavioral utility functions to provide a more accurate representation of these anomalies. To evaluate the model’s performance, the standard function used in expected utility theory and behavioral utility functions are tested under both normal and Normal Inverse Gaussian (NIG) distributions. The findings indicate that the conventional utility function fails to capture the observed smirk patterns. In contrast, the behavioral utility function generates the IV smirks that closely align with empirical shapes, even under the normal distribution. These results highlight the effectiveness of the utility indifference model with behavioral utility functions in explaining these stylized facts that standard models struggle to reproduce. | |
