Cumulative Prospect Theory, Option Returns, and the Variance Premium

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

See all articles by Lieven Baele

Lieven Baele

Tilburg University - Department of Finance

Joost Driessen

Tilburg University - Tilburg University School of Economics and Management; Tilburg University - Center for Economic Research (CentER)

Sebastian Ebert

Heidelberg University

Juan M. Londono

Board of Governors of the Federal Reserve System

Oliver G. Spalt

University of Mannheim - Business School; European Corporate Governance Institute (ECGI)

Multiple version iconThere are 3 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 - Tilburg University School of Economics and Management ( 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

Heidelberg University ( email )

Grabengasse 1
Heidelberg, 69117
Germany
06221543443 (Phone)
69115 (Fax)

Juan M. Londono (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Oliver G. Spalt

University of Mannheim - Business School ( email )

L5, 5
Mannheim, 68131
Germany

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

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