Probability Weighting Functions Implied in Options Prices

62 Pages Posted: 15 Dec 2012

See all articles by Valery Polkovnichenko

Valery Polkovnichenko

Federal Reserve Board - Divison of Research and Statistics

Feng Zhao

University of Texas at Dallas - Jindal School of Management

Date Written: January 1, 2012

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 (Ait-Sahalia and Lo, 2000; and 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 over-weights tail events. We also estimate the pricing kernels non-parametrically from the S&P 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.

Keywords: pricing kernel, non-parametric estimation, probability weighting, rank-dependent utility

JEL Classification: G12, G13

Suggested Citation

Polkovnichenko, Valery and Zhao, Feng, Probability Weighting Functions Implied in Options Prices (January 1, 2012). Available at SSRN: https://ssrn.com/abstract=2189482 or http://dx.doi.org/10.2139/ssrn.2189482

Valery Polkovnichenko (Contact Author)

Federal Reserve Board - Divison of Research and Statistics ( email )

20th and C Streets, NW
Washington, DC 20551
United States

Feng Zhao

University of Texas at Dallas - Jindal School of Management ( email )

800 W. Campbell Rd. SM 31
Richardson, TX 75080
United States
972-883-5815 (Phone)

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