Cumulative Prospect Theory, Option Returns, and the Variance Premium

Lieven Baele, Joost Driessen, Sebastian Ebert, Juan M. Londono and Oliver G Spalt

The Review of Financial Studies, 2019, vol. 32, issue 9, 3667-3723

Abstract: We develop a tractable equilibrium asset pricing model with cumulative prospect theory (CPT) preferences. Using GMM on a sample of U.S. equity index option returns, we show that by introducing a single common probability weighting parameter for both tails of the return distribution, the CPT model can simultaneously generate the otherwise puzzlingly low returns on both out-of-the-money put and out-of-the-money call options as well as the high observed variance premium. In a dynamic setting, probability weighting and time-varying equity return volatility combine to match the observed time-series pattern of the variance premium. Received May 30, 2017; editorial decision August 10, 2018 by Editor Andrew Karolyi.

Date: 2019
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