Market Instability, Investor Sentiment, And Probability Judgment Error in Index Option Prices

G. Charles-Cadogan
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G. Charles-Cadogan: University of Leicester

CRETA Online Discussion Paper Series from Centre for Research in Economic Theory and its Applications CRETA

Abstract: In a natural experiment with index option prices, we study how probability judgment error, and probabilistic risk attitudes, characterize investors’ sentiment about the ranking of index option attractiveness, the weight they place on each rank, and their ability to discriminate between prices. We introduce a novel behavioral process that (1) characterizes investor sentiment about tail events in index option prices over time and probability ranks, (2) provides early warning signals of market instability, and (3) crash probability estimates from a closed form expression for the time varying transition probability that a seemingly stable market state will become unstable and crash.

Keywords: sentiment; crash risk; probability weighting function; index option prices; market instability JEL codes: C02; C44; D03; D81; G01; G12 (search for similar items in EconPapers)
Date: 2021
New Economics Papers: this item is included in nep-rmg
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