Topic: Cumulative Prospect Theory and the Variance Premium

Speaker:Juan-Miguel Londono-Yarce, Economist, Federal Reserve Board

Date: September 16th (Wed.)

Time: 2:00-3:30pm  

Location: Building 4, Room 101

Language: English

Abstract:

Cumulative Prospect Theory (CPT) can explain the variance premium puzzle. We solve an 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 estimates probability distortion parameter implies that real-world investors in option markets distort probabilities significantly, but less so than subjects in lab experiments. In a dynamic setting, probability weighting and time-varying equity return volatility combine to match the observed time-series pattern of the variance premium

About the speaker:

Juan-Miguel Londono-Yarce is the economist at Global Capital Markets Section of Federal Reserve Board since 2011. Dr. Yarce received a Ph.D. in Quantitative Finance from Basque Country University in 2009, and a Ph.D. in Business from Tilburg University in 2011. His current research topics are stock and currency variance risk premiums and cumulative prospect theory. His papers have appeared in Jounal of International Money and Finance, Empirical Finance, International Review of Economics and Finance and other leading journals.