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Single Stock Call Options as Lottery Tickets - Overpricing and Investor Sentiment

Listed author(s):
  • Luiz Félix

    (VU University Amsterdam, the Netherlands)

  • Roman Kräussl

    (University of Luxembourg, Luxemburg)

  • Philip Stork

    (VU University Amsterdam, the Netherlands)

This paper investigates whether the overpricing of out-of-the money single stock calls can be explained by Tversky and Kahneman's (1992) cumulative prospect theory (CPT). We argue that these options are overpriced because investors' overweight small probability events and overpay for such positively skewed securities, i.e., characteristics of lottery tickets. We match a set of subjective density functions derived from risk-neutral densities, including the CPT with the empirical probability distribution of U.S. equity returns. We find that overweighting of small probabilities embedded in the CPT explains on average the richness of out-of-the money single stock calls better than other utility functions. The degree that agents overweight small probability events is, however, strongly time-varying and has a horizon effect, which implies that it is less pronounced in options of longer maturity. We also find that time-variation in overweighting of small probabilities is strongly explained by market sentiment, as in Baker and Wurgler (2007).

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Paper provided by Tinbergen Institute in its series Tinbergen Institute Discussion Papers with number 16-022/IV.

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Date of creation: 01 Apr 2016
Date of revision: 01 Jan 2017
Handle: RePEc:tin:wpaper:20160022
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  1. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
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  3. Danielsson, Jon & Jorgensen, Bjorn N. & Sarma, Mandira & de Vries, Casper G., 2006. "Comparing downside risk measures for heavy tailed distributions," Economics Letters, Elsevier, vol. 92(2), pages 202-208, August.
  4. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
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  12. Félix, Luiz & Kräussl, Roman & Stork, Philip, 2016. "The 2011 European short sale ban: A cure or a curse?," Journal of Financial Stability, Elsevier, vol. 25(C), pages 115-131.
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