Cumulative Prospect Theory, Option Returns, and the Variance Premium
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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.
2012 ◽
pp. 372-404
2008 ◽
Vol 98
(5)
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pp. 2066-2100
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2018 ◽
Vol 16
(1-2)
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pp. 249-274
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