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Does Implied Volatility Pricing Follow the Tenets of Prospect Theory?

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  • François Desmoulins-Lebeault
  • Luc Meunier
  • Sima Ohadi

Abstract

Prospect theory and behavioral finance are gaining recognition as useful frameworks for the analysis of economic behaviors. Yet, behavioral finance is generally concerned with specific anomalies and individual behaviors and does not deal with market indices. To bridge this gap, the authors studied the changes in the value of implied volatility indices on several markets, relative to changes in the level of the corresponding equity indices with dividends reinvestment. We hypothesized that the relation should follow the psychological tenets of prospect theory. In accordance with this hypothesis, the authors found concavity in the gain area, convexity in the loss area, and evidence that market losses have more impact than gains on the pricing of implied volatility indices. These findings are observed in all the markets under consideration and are robust to the use of different functional forms. The parameters are in the range observed in previous laboratory studies but vary in different trading environments.

Suggested Citation

  • François Desmoulins-Lebeault & Luc Meunier & Sima Ohadi, 2020. "Does Implied Volatility Pricing Follow the Tenets of Prospect Theory?," Journal of Behavioral Finance, Taylor & Francis Journals, vol. 21(2), pages 157-173, April.
    • Handle: RePEc:taf:hbhfxx:v:21:y:2020:i:2:p:157-173
    DOI: 10.1080/15427560.2019.1663851
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    Cited by:

    1. Giannikos, Christos I. & Kakolyris, Andreas & Suen, Tin Shan, 2023. "Prospect theory and a manager's decision to trade a blind principal bid basket," Global Finance Journal, Elsevier, vol. 55(C).
    2. Aleksandar Radic & Michael Lück & Amr Al-Ansi & Bee-Lia Chua & Sabrina Seeler & António Raposo & Jinkyung Jenny Kim & Heesup Han, 2021. "To Dine, or Not to Dine on a Cruise Ship in the Time of the COVID-19 Pandemic: The Tripartite Approach towards an Understanding of Behavioral Intentions among Female Passengers," Sustainability, MDPI, vol. 13(5), pages 1-17, February.

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