Option Portfolio Design for Prospect Theory Agents

The traditional model of financial portfolio design is grounded in expected returns and risk, typically measured by the variance, adhering to the expected utility framework (Markowitz, 1952; Sharpe, 1964). However, empirical and theoretical advancements suggest that higher moments, such as skewness, also significantly influence investment decisions (Kraus & Litzenberger, 1976). Prospect theory, introduced by Kahneman and Tversky (1979), further emphasizes that risk attitudes encompass more than just variance, highlighting loss aversion and probability weighting (Barberis & Huang, 2008;
Spalt, 2013).