Cumulative Prospect Theory, Option Returns, and the Variance Premium

82 Pages Posted: 21 Mar 2014 Last revised: 17 Jun 2018

Lieven Baele

Tilburg University - Department of Finance

Joost Driessen

Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - Center for Economic Research (CentER)

Sebastian Ebert

Frankfurt School of Finance & Management gemeinnützige GmbH

Juan M. Londono

Federal Reserve Board of Governors

Oliver G. Spalt

Tilburg University - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: May 29, 2017

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 (OTM) put and OTM call options. Since the variance premium can be written as the expected return on a portfolio of OTM call and put options, the CPT model also fits 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.

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 (May 29, 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 - Center and Faculty of Economics and Business Administration ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Sebastian Ebert

Frankfurt School of Finance & Management gemeinnützige GmbH ( email )

Sonnemannstraße 9-11
Frankfurt am Main, 60314
Germany

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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