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Probability weighting functions implied in options prices

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  • Polkovnichenko, Valery
  • Zhao, Feng

Abstract

The empirical pricing kernels estimated from index options are non-monotone (Rosenberg and Engle, 2002; Bakshi, Madan, and Panayotov, 2010) and the corresponding risk-aversion functions can be negative (Aït-Sahalia and Lo, 2000; Jackwerth, 2000). We show theoretically that these and several other properties of empirical pricing kernels are consistent with rank-dependent utility model with probability weighting function, which overweights tail events. We also estimate the pricing kernels nonparametrically from the Standard & Poor's 500 index options and construct empirical probability weighting functions. The estimated probability weights typically have the inverse-S shape, which overweights tail events and is widely supported by the experimental decision theory.

Suggested Citation

  • Polkovnichenko, Valery & Zhao, Feng, 2013. "Probability weighting functions implied in options prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 580-609.
    • Handle: RePEc:eee:jfinec:v:107:y:2013:i:3:p:580-609
    DOI: 10.1016/j.jfineco.2012.09.008
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    More about this item

    Keywords

    Pricing kernel; Nonparametric estimation; Probability weighting; Rank-dependent utility;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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