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Cumulative Prospect Theory, Option Returns, and the Variance Premium

Author

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  • Lieven Baele
  • Joost Driessen
  • Sebastian Ebert
  • Juan M Londono
  • Oliver G Spalt

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. Received May 30, 2017; editorial decision August 10, 2018 by Editor Andrew Karolyi.

Suggested Citation

  • Lieven Baele & Joost Driessen & Sebastian Ebert & Juan M Londono & Oliver G Spalt, 2019. "Cumulative Prospect Theory, Option Returns, and the Variance Premium," Review of Financial Studies, Society for Financial Studies, vol. 32(9), pages 3667-3723.
  • Handle: RePEc:oup:rfinst:v:32:y:2019:i:9:p:3667-3723.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy127
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    Cited by:

    1. Geert Bekaert & Eric C. Engstrom & Nancy R. Xu, 2022. "The Time Variation in Risk Appetite and Uncertainty," Management Science, INFORMS, vol. 68(6), pages 3975-4004, June.
    2. Juan M. Londono & Nancy R. Xu, 2021. "The Global Determinants of International Equity Risk Premiums," International Finance Discussion Papers 1318, Board of Governors of the Federal Reserve System (U.S.).
    3. Nicholas C. Barberis & Lawrence J. Jin & Baolian Wang, 2020. "Prospect Theory and Stock Market Anomalies," NBER Working Papers 27155, National Bureau of Economic Research, Inc.
    4. Benjamin L. Collier & Daniel Schwartz & Howard C. Kunreuther & Erwann O. Michel‐Kerjan, 2022. "Insuring large stakes: A normative and descriptive analysis of households' flood insurance coverage," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 89(2), pages 273-310, June.
    5. Sanjay K. Nawalkha & Xiaoyang Zhuo, 2022. "A Theory of Equivalent Expectation Measures for Contingent Claim Returns," Journal of Finance, American Finance Association, vol. 77(5), pages 2853-2906, October.
    6. Sanjay K. Nawalkha & Xiaoyang Zhuo, 2020. "A Theory of Equivalent Expectation Measures for Contingent Claim Returns," Papers 2006.15312, arXiv.org, revised May 2022.
    7. Nawalkha, Sanjay K & Zhuo, Xiaoyang, 2020. "A Theory of Equivalent Expectation Measures for Expected Prices of Contingent Claims," OSF Preprints hsxtu, Center for Open Science.
    8. Payzan-LeNestour, Elise & Pradier, Lionnel & Putniņš, Tālis J., 2023. "Biased risk perceptions: Evidence from the laboratory and financial markets," Journal of Banking & Finance, Elsevier, vol. 154(C).
    9. Gupta, Nilesh & Mishra, Anil V & Jacob, Joshy, 2022. "Prospect theory preferences and global mutual fund flows," Journal of International Money and Finance, Elsevier, vol. 125(C).
    10. Jun Yuan & Qi Xu & Ying Wang, 2023. "Probability weighting in commodity futures markets," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(4), pages 516-548, April.
    11. Jason Brown & Nida Çakır Melek & Johannes Matschke & Sai Sattiraju, 2023. "The Missing Tail Risk in Option Prices," Research Working Paper RWP 23-02, Federal Reserve Bank of Kansas City.
    12. Nicholas Barberis & Lawrence J. Jin & Baolian Wang, 2021. "Prospect Theory and Stock Market Anomalies," Journal of Finance, American Finance Association, vol. 76(5), pages 2639-2687, October.
    13. Charles-Cadogan, G., 2021. "Market Instability, Investor Sentiment, And Probability Judgment Error in Index Option Prices," CRETA Online Discussion Paper Series 71, Centre for Research in Economic Theory and its Applications CRETA.

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