Abstract
| Original language | English |
|---|---|
| Publisher | SSRN |
| Number of pages | 74 |
| DOIs | |
| Publication status | Published - May 2017 |
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Keywords
- cumulative prospect theory
- variance risk premium
- probability weighting
Cite this
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Cumulative Prospect Theory, Option Returns, and the Variance Premium. / Baele, Lieven; Driessen, Joost; Ebert, Sebastian; Londono Yarce, J.M.; Spalt, Oliver.
SSRN, 2017.Research output: Working paper › Other research output
TY - UNPB
T1 - Cumulative Prospect Theory, Option Returns, and the Variance Premium
AU - Baele, Lieven
AU - Driessen, Joost
AU - Ebert, Sebastian
AU - Londono Yarce, J.M.
AU - Spalt, Oliver
PY - 2017/5
Y1 - 2017/5
N2 - The variance premium and the pricing of out-of-the-money (OTM) equity index options are major challenges to standard asset pricing models. We develop a tractable equilibrium model with Cumulative Prospect Theory (CPT) preferences that can overcome both challenges. The key insight is that the variance premium can be written as the expected return on a portfolio of OTM call and put options, and the probability weighting feature of CPT can explain the puzzlingly low returns observed for these options. Using GMM on a sample of U.S. index option returns between 1996 and 2010, we show that the CPT model ts well observed option prices and, therefore, the 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.
AB - The variance premium and the pricing of out-of-the-money (OTM) equity index options are major challenges to standard asset pricing models. We develop a tractable equilibrium model with Cumulative Prospect Theory (CPT) preferences that can overcome both challenges. The key insight is that the variance premium can be written as the expected return on a portfolio of OTM call and put options, and the probability weighting feature of CPT can explain the puzzlingly low returns observed for these options. Using GMM on a sample of U.S. index option returns between 1996 and 2010, we show that the CPT model ts well observed option prices and, therefore, the 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.
KW - cumulative prospect theory
KW - variance risk premium
KW - probability weighting
U2 - 10.2139/ssrn.2411577
DO - 10.2139/ssrn.2411577
M3 - Working paper
BT - Cumulative Prospect Theory, Option Returns, and the Variance Premium
PB - SSRN
ER -