Article2000

Recovering Risk Aversion from Option Prices and Realized Returns

837 citations0/0 files storedReview of Financial Studies

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Stochastic processes and financial applications Financial Markets and Investment Strategies Decision-Making and Behavioral Economics

Abstract

A relationship exists between aggregate risk-neutral and subjective probability distributions and risk aversion functions. We empirically derive risk aversion functions implied by options prices and realized returns on the S&P500 index simultaneously. These risk aversion functions dramatically change shapes around the 1987 crash: Precrash, they are positive and decreasing in wealth and largely consistent with standard assumptions made in economic theory. Postcrash, they are partially negative and partially increasing and irreconcilable with those assumptions. Mispricing in the option market is the most likely cause. Simulated trading strategies exploiting this mispricing show excess returns, even after accounting for the possibility of further crashes, transaction costs, and hedges against the downside risk.

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References

1980On estimating the expected return on the market 1978Prices of State-Contingent Claims Implicit in Option Prices 1994Implied Binomial Trees 1976The Valuation of Uncertain Income Streams and the Pricing of Options 1998Implied Volatility Functions: Empirical Tests 1996Recovering Probability Distributions from Option Prices 1998Nonparametric Estimation of State‐Price Densities Implicit in Financial Asset Prices 1976Options and Efficiency

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2005Demand-Based Option Pricing 2001Expected Option Returns 2001Characteristics of Risk and Return in Risk Arbitrage 2002Empirical pricing kernels 2004Option‐Implied Risk Aversion Estimates 2003Extreme Value Dependence in Financial Markets: Diagnostics, Models, and Financial Implications 2004Risk and Volatility: Econometric Models and Financial Practice

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