Review of Financial Studies Vol. 32 No. 9 2019
Cumulative Prospect Theory, Option Returns, and the Variance Premium
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 put and out-of-the-money call options as well as 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. Received May 30, 2017; editorial decision August 10, 2018 by Editor Andrew Karolyi.
- DOI
- 10.1093/rfs/hhy127
- Volume
- 32
- Issue
- 9
- Pages
- 3667-3723
- Language
- en
- Sources
- bibtex:phds-export.bib openalex crossref