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Recovering Risk Aversion from Option Prices and Realized Returns

Subject

Finance

Publishing details

IFA Working Paper

Publication Year

1997

Abstract

A relationship exists between aggregate risk-neutral and subjective probability distributions and risk aversion functions. Using a variation of the method developed by Jackwerth and Rubinstein (1996), we estimate risk-neutral probabilities reliably from option prices. Subjective probabilities are estimated from realized returns. This paper then introduces a technique to empirically derive risk aversion functions implied by option prices and realized returns simultaneously. These risk aversion functions dramatically change shapes around the 1987 crash: Precrash, they are positive and decreasing in wealth and thus consistent with standard economic theory. Postcrash, they are partially negative and increasing and irreconcilable with the theory. Overpricing of out-of-the-money puts is the most likely cause. A simulated trading strategy exploiting this overpricing shows excess returns even after accounting for the possibility of further crashes and transaction costs.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 261

Series

IFA Working Paper

Available on ECCH

No


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