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

We develop a tractable equilibrium asset pricing model with cumulative prospect theory (CPT) preferences. Using GMM on a sample of U.S. equity index option returns, we show that by introducing a single common probability weighting parameter for both tails of the return distribution, the CPT model can simultaneously generate the otherwise puzzlingly low returns on both out-of-the-money put and out-of-the-money call options as well as the high observed 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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