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.

Netspar, Network for Studies on Pensions, Aging and Retirement, is een denktank en kennisnetwerk. Netspar is gericht op een goed geïnformeerd pensioendebat.


Missie en strategie           •           Netwerk           •           Organisatie           •          Podcasts
Board Brief            •            Werkprogramma 2023-2027           •           Onderzoeksagenda


Onze partners

B20211216_shell download
B20200924_Ortec Finance logo 250px_banner_small
Bekijk al onze partners