Generalized Black-Scholes Option Pricing and Investor Sentiment

Abstract This paper extends the standard Black-Scholes (BS) option pricing framework by utilizing the generalized solution to the heat equation proposed by Choi et al. (2017). We present the closed-form solution for a generalized BS (GBS) model and show that the modification to the standard call option price comes from two additional augments interpreted as factors associated with investor sentiment toward the underlying asset. Our model outperforms the standard BS model in both in-sample fit and out-of-sample prediction on S&P 500 index option data. Further analysis shows that the parameters for the newly incorporated terms strongly reflect investors expectation and help better explain how option market prices tend to drift from the BS model.