Cumulative prospect theory, option returns and the variance premium

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

Research output: Contribution to journalArticleScientificpeer-review

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 fits 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
Pages (from-to)3667-3723
JournalThe Review of Financial Studies
Volume32
Issue number9
Early online dateDec 2018
DOIs
Publication statusPublished - Sep 2019

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Cumulative prospect theory
Premium
Probability weighting
Index options
Equity returns
Equity
Asset pricing models
Time-varying
Call option
Option prices
Put option
Pricing
Return volatility
Expected returns

Cite this

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title = "Cumulative prospect theory, option returns and the variance premium",
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 thatthe CPT model fits 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.",
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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.

In: The Review of Financial Studies, Vol. 32, No. 9, 09.2019, p. 3667-3723.

Research output: Contribution to journalArticleScientificpeer-review

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