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Cumulative Prospect Theory, Option Returns, and the Variance Premium

73 Pages Posted: 21 Mar 2014 Last revised: 11 Mar 2017

Lieven Baele

Tilburg University - Department of Finance

Joost Driessen

Tilburg University - Department of Finance; CentER Tilburg University

Sebastian Ebert

Tilburg University

Juan M. Londono

Federal Reserve Board of Governors

Oliver G. Spalt

Tilburg University - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: March 3, 2017

Abstract

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

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

Lieven Baele

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 3257 (Phone)
+31 13 466 2875 (Fax)

Joost Driessen

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

CentER Tilburg University ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Sebastian Ebert

Tilburg University ( email )

P.O. Box 90153
Tilburg, DC 5000 LE
Netherlands

Juan-Miguel Londono-Yarce (Contact Author)

Federal Reserve Board of Governors ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States

Oliver G. Spalt

Tilburg University - Department of Finance ( email )

Department of Finance
Tilburg University
Tilburg, 5000 LE
Netherlands
+31 13 466 3545 (Phone)

HOME PAGE: http://www.oliverspalt.com

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