Cumulative Prospect Theory, Option Returns, and the Variance Premium

Lieven Baele, Joost Driessen, Sebastian Ebert, J.M. Londono Yarce, Oliver Spalt

Research output: Working paperOther research output

Abstract

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.
Original languageEnglish
PublisherSSRN
Number of pages74
DOIs
Publication statusPublished - May 2017

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Keywords

  • cumulative prospect theory
  • variance risk premium
  • probability weighting

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