1 Introduction
Recently, traditional financial theories of asset pricing have come under inten-
sive discussion. Quite a number of market phenomena have been discovered
which cannot or at least cannot easily be explained by traditional theories.
The equity premium puzzle [Mehra and Prescot 1985], short- and long term
predictability of stock returns [Jegadeesh and Titman 1993, De Bondt and
Thaler 1985], high volatility of stock prices [Shiller 1981, 1989] and the
success of strategies based on value and size [Vuolteenaho 2000] are just ex-
amples for those phenomena. Interestingly enough these puzzles are not only
found at the New York Stock Exchange but they are also present in markets
world wide, see, e.g., Rouwenhorst (1998) and Schiereck, De Bondt and We-
ber (2000) for the persistence of short-term predictability. These results are
complemented by the analysis of individual trading behavior ∖ Odean 1998 a]
which reflects biases known from psychological research as well as from exper-
imental work which clearly shows that expected utility does not adequately
describe peoples’ behavior ∖Gneezy and Potters 1997, Sarin and Weber 1993,
Thaler et al. 1997, Weber and Camerer 1998].
The question remains if these puzzles can be solved within the framework
of expected utility (EU) or if new theories incorporating behavioral ideas
are needed. Ultimately those theories will be chosen which can explain the
(some) puzzles and which are based on more meaningful assumptions. In the
following, we will present a behavioral asset pricing theory which is based
on more realistic behavioral assumptions. This theory allows us to address
the important question which impact heterogeneity of investors has on asset
pricing, in particular, on option pricing.
Quite a number of different behavioral theories have been developed
lately. Most of them focus on specific behavioral aspects of individual deci-