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

Frankfurt School of Finance & Management gemeinn├╝tzige GmbH

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-Yarce, Juan-Miguel 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

Frankfurt School of Finance & Management gemeinn├╝tzige GmbH ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Juan-Miguel Londono-Yarce (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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