Does Implied Volatility Pricing Follow the Tenets of Prospect Theory?

François Desmoulins-Lebeault, Luc Meunier and Sima Ohadi

Journal of Behavioral Finance, 2020, vol. 21, issue 2, 157-173

Abstract: Prospect theory and behavioral finance are gaining recognition as useful frameworks for the analysis of economic behaviors. Yet, behavioral finance is generally concerned with specific anomalies and individual behaviors and does not deal with market indices. To bridge this gap, the authors studied the changes in the value of implied volatility indices on several markets, relative to changes in the level of the corresponding equity indices with dividends reinvestment. We hypothesized that the relation should follow the psychological tenets of prospect theory. In accordance with this hypothesis, the authors found concavity in the gain area, convexity in the loss area, and evidence that market losses have more impact than gains on the pricing of implied volatility indices. These findings are observed in all the markets under consideration and are robust to the use of different functional forms. The parameters are in the range observed in previous laboratory studies but vary in different trading environments.

Date: 2020
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DOI: 10.1080/15427560.2019.1663851

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