Π-CAPM: An Asset Pricing Model with Probability Weighting

64 Pages Posted: 28 Nov 2020

See all articles by Joost Driessen

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 gemeinnützige GmbH

Joren Koëter

Department of Finance; Tilburg University - Center for Economic Research (CentER)

Date Written: October 14, 2020

Abstract

We study the asset pricing implications of probability weighting—the idea that investors overweight rare, high impact events—by generalizing the mean-variance framework to allow for tail overweighting. Our model allows for a unique and homogenous pricing equilibrium with multiple investors and several correlated assets. We find that even a symmetric probability distortion has asymmetric pricing implications. For example, while the price of a left-skewed asset increases in skewness and decreases in variance, the price of a right-skewed asset may not. We also obtain and empirically validate several novel implications on the option-implied premiums on variance, skewness, and correlation.

Keywords: asset pricing, behavioral finance, probability weighting, option markets

JEL Classification: G02, G11, G12

Suggested Citation

Driessen, Joost and Ebert, Sebastian and Koëter, Joren, Π-CAPM: An Asset Pricing Model with Probability Weighting (October 14, 2020). Available at SSRN: https://ssrn.com/abstract=3711478

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 gemeinnützige GmbH ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Joren Koëter (Contact Author)

Department of Finance; Tilburg University - Center for Economic Research (CentER) ( email )

P.O. Box 90153
Tilburg, DC Noord-Brabant 5000 LE
Netherlands

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