Recovering risk aversion from option prices and realized returns |
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Authors: | Jackwerth JC |
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Institution: | University of Wisconsin, 975 University Avenue, Room 5279, Madison, WI 53706, USA
E-mail: jjackwerth@bus.wisc.edu |
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Abstract: | A relationship exists between aggregate risk-neutral and subjectiveprobability distributions and risk aversion functions. We empiricallyderive risk aversion functions implied by options prices andrealized returns on the S&P500 index simultaneously. Theserisk aversion functions dramatically change shapes around the1987 crash: Precrash, they are positive and decreasing in wealthand largely consistent with standard assumptions made in economictheory. Postcrash, they are partially negative and partiallyincreasing and irreconcilable with those assumptions. Mispricingin the option market is the most likely cause. Simulated tradingstrategies exploiting this mispricing show excess returns, evenafter accounting for the possibility of further crashes, transactioncosts, and hedges against the downside risk. |
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