Universität Bonn

Department of Economics

Sebastian Ebert - University of Heidelberg

"Π-CAPM: The Classical CAPM with Probability Weighting and Skewed Assets", together with Joost Driessen & Joren Koëter

Abstract

We propose a new asset pricing model which generalizes the mean-variance framework by including probability weighting, specifically the overweighting of rare, high-impact events. Our model—the Π-CAPM—allows for disentangling the price impact of volatility and skewness. We show that the price impact of volatility is skewness-dependent, negative for left-skewed assets but potentially positive for right-skewed assets. Further, probability weighting translates into an exaggerated co-movement of assets and can explain the empirical correlation premium. Finally, we empirically verify that option-implied variance premiums for individual stocks depend on the stock’s skewness, in the way predicted by the Π-CAPM.

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