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.
Baele, L., Driessen, J., Ebert, S., Londono Yarce, J. M., & Spalt, O. (2019). Cumulative prospect theory, option returns and the variance premium. The Review of Financial Studies, 32(9), 3667-3723. https://doi.org/10.1093/rfs/hhy127