Cumulative prospect theory, option returns and the variance premium

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
JournalThe Review of Financial Studies
DOIs
Publication statusE-pub ahead of print - Dec 2018

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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.",
author = "Lieven Baele and Joost Driessen and Sebastian Ebert and {Londono Yarce}, J.M.",
year = "2018",
month = "12",
doi = "10.1093/rfs/hhy127",
language = "English",
journal = "The Review of Financial Studies",
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publisher = "Oxford University Press",

}

Cumulative prospect theory, option returns and the variance premium. / Baele, Lieven; Driessen, Joost; Ebert, Sebastian; Londono Yarce, J.M.

In: The Review of Financial Studies, 12.2018.

Research output: Contribution to journalArticleScientificpeer-review

TY - JOUR

T1 - Cumulative prospect theory, option returns and the variance premium

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AU - Driessen, Joost

AU - Ebert, Sebastian

AU - Londono Yarce, J.M.

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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 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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DO - 10.1093/rfs/hhy127

M3 - Article

JO - The Review of Financial Studies

JF - The Review of Financial Studies

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