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We derive behavioral finance option pricing formulas consistent with therational dynamic asset pricing theory. In the existing behavioral financeoption pricing formulas, the price process of the representative agent is not asemimartingale, which leads to arbitrage opportunities for the option seller.In the literature on behavioral finance option pricing it is allowed the optionbuyer and seller to have different views on the instantaneous mean return ofthe underlying price process, which leads to arbitrage opportunities accordingto Black (1972). We adjust the behavioral finance option pricing formulas to beconsistent with the rational dynamic asset pricing theory, by introducingtransaction costs on the velocity of trades which offset the gains from thearbitrage trades.

Behavioral Finance Option Pricing Formulas Consistent with Rational Dynamic Asset Pricing