Valuation of Options in a Setting with Happiness-Augmented Preferences

Abstract

We derive a pricing formula for a European call option written on equity in a framework where returns and consumption covary with external happiness. Being a non-tradable variable, happiness is regarded as an extra variable in a parameterised version of state dependent utility. We derive an extended version of the Black-Scholes (BS) formula and find that, in an optimistic environment (that is, where a high growth rate of happiness is expected), the standard BS formula may underestimate the value of the call option, and overestimate its sensitivity to changes in the underlying parameters. Under the assumption of lognormality of the happiness distribution, testable hypotheses for quality of hedging strategies can also be implemented.