Cumulative Prospect Theory and the Variance Premium

45 Pages Posted: 2 Nov 2014 Last revised: 12 Dec 2014

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)

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: October 31, 2014

Abstract

Cumulative Prospect Theory (CPT) can explain the variance premium puzzle. We solve a simple equilibrium model with CPT investors and find that probability weighting plays a key role in generating a substantial variance premium, while loss aversion captures the equity premium. Using GMM on a sample of U.S. equity and index-option returns between 1996 and 2010, our estimate of the probability distortion parameter implies that real-world investors in option markets distort probabilities significantly, but less so than subjects in lab experiments. We also show that the CPT model prices the cross-section of out-of-the-money index options 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, distorted probabilities, loss aversion, variance risk premium.

JEL Classification: C15, G11, G13

Suggested Citation

Baele, Lieven and Driessen, Joost and Londono-Yarce, Juan-Miguel and Spalt, Oliver G., Cumulative Prospect Theory and the Variance Premium (October 31, 2014). Available at SSRN: https://ssrn.com/abstract=2517657 or http://dx.doi.org/10.2139/ssrn.2517657

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

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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