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Π-CAPM: The Classical CAPM with Probability Weighting and Skewed Assets

Joost Driessen¹; Sebastian Ebert²; Joren Koëter³

¹ Tilburg University · ² Heidelberg University · ³ Rotterdam School of Management Erasmus University

Abstract We propose a new asset pricing model that generalizes the mean-variance framework by including probability weighting, specifically the overweighting of rare, high-impact events. Our model—the $ Π $-CAPM—generates several new predictions: (i) skewness has a positive price effect, amplified by volatility; (ii) the price effect of volatility is negative for left-skewed assets but positive for right-skewed assets; and (iii) option-implied variance premiums for stocks have a U-shaped relation to skewness, amplified by volatility. We find strong empirical support for these predictions. Finally, we show that the $ Π $-CAPM predicts an exaggerated co-movement of assets and can explain the correlation premium.

DOI

10.1093/rfs/hhaf045

Volume

38 (12)

Pages

3497-3541

Language

en

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