Probability weighting functions implied in options prices

Valery Polkovnichenko and Feng Zhao

Journal of Financial Economics, 2013, vol. 107, issue 3, 580-609

Abstract: The empirical pricing kernels estimated from index options are non-monotone (Rosenberg and Engle, 2002; Bakshi, Madan, and Panayotov, 2010) and the corresponding risk-aversion functions can be negative (Aït-Sahalia and Lo, 2000; Jackwerth, 2000). We show theoretically that these and several other properties of empirical pricing kernels are consistent with rank-dependent utility model with probability weighting function, which overweights tail events. We also estimate the pricing kernels nonparametrically from the Standard & Poor's 500 index options and construct empirical probability weighting functions. The estimated probability weights typically have the inverse-S shape, which overweights tail events and is widely supported by the experimental decision theory.

Keywords: Pricing kernel; Nonparametric estimation; Probability weighting; Rank-dependent utility (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (47)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:107:y:2013:i:3:p:580-609

DOI: 10.1016/j.jfineco.2012.09.008

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