Abstract

We study asset prices in a generalized mean-variance framework that allows for probability weighting (the idea that investors overweight rare, high impact events). The resulting model – the Pi-CAPM – allows for a unique and homogeneous pricing equilibrium with skewed and correlated assets and a tractable analysis thereof. We find that even symmetric probability weighting has asymmetric pricing implications. For example, the price impact of volatility is skewness-dependent, negative for left-skewed assets but potentially positive for right-skewed assets. We further find that probability weighting translates into an exaggerated dependence between the assets. Finally, we make an empirical contribution and show that the option-implied premiums on variance and skewness depend on the underlying asset’s skewness, in the very way that is predicted by the Pi-CAPM.