73 Pages Posted: 21 Mar 2014 Last revised: 11 Mar 2017
Date Written: March 3, 2017
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 that 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 observed option prices and, therefore, the variance premium well. In a dynamic setting, probability weighting and time-varying equity return volatility combine to match the observed time-series pattern of the variance premium.
Keywords: Cumulative prospect theory, variance risk premium, probability weighting
JEL Classification: C15, G11, G13
Suggested Citation: Suggested Citation
Baele, Lieven and Driessen, Joost and Ebert, Sebastian and Londono, Juan M. and Spalt, Oliver G., Cumulative Prospect Theory, Option Returns, and the Variance Premium (March 3, 2017). Available at SSRN: https://ssrn.com/abstract=2411577 or http://dx.doi.org/10.2139/ssrn.2411577