This paper investigates whether the overpricing of out-of-the money single stock calls can be explained by Tversky and Kahneman's (1992) cumulative prospect theory (CPT). We hypothesize that these options are overpriced because investors overweight small probability events and overpay for positively skewed securities, i.e, lottery tickets. We find that overweighting of small probabilities embedded in the CPT explains the richness of out-of-the money single stock calls better than other utility functions. Nevertheless, overweighting of small probabilities events is less pronounced than suggested by the CPT, is strongly time-varying and most frequent in options of short maturity. Fluctuations in overweighting of small probabilities are largely explained by the sentiment factor.
# 16-022/IV (2016-04-01; 2018-01-26)
- Luiz Felix, VU University Amsterdam, the Netherlands; Roman Kraussl, University of Luxembourg, Luxemburg; Philip Stork, VU University Amsterdam, the Netherlands
- Cumulative prospect theory, Market sentimen, Risk-neutral densities, Call options
- JEL codes:
- G02, G12