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Estimating Probability Weighting Functions through Option Pricing Bounds

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  • Tzu-Ying Chen
  • Yo-Lan Lin
  • Larry Y Tzeng

Abstract

This paper proposes a novel approach to estimating the probability weighting function (PWF) of investors in the option market. We match observed option prices to the option pricing bounds under stochastic dominance rules. Using 1-month S&P 500 index option data, we find that investors could subjectively employ an inverse S-shaped probability weighting function, which increases the weights on extreme returns and asymmetrically assigns greater weights to extremely low returns than to extremely high returns. Our findings suggest that the inverse S-shaped nature of the PWFs is robust across various estimation specifications, such as adopting an alternative methodology to construct the return distribution, and employing option data with different times to maturity. (JEL G12)

Suggested Citation

  • Tzu-Ying Chen & Yo-Lan Lin & Larry Y Tzeng, 2024. "Estimating Probability Weighting Functions through Option Pricing Bounds," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 14(3), pages 513-543.
    • Handle: RePEc:oup:rasset:v:14:y:2024:i:3:p:513-543.
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    File URL: http://hdl.handle.net/10.1093/rapstu/raae008
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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