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Recovering Risk Aversion from Option Prices and Realized Returns

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  • Jackwerth, Jens Carsten

Abstract

A relationship exists between aggregate risk-neutral and subjective probability distributions and risk aversion functions. We empirically derive risk aversion functions implied by option prices and realized returns on the S&P 500 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. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 13 (2000)
Issue (Month): 2 ()
Pages: 433-51

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Handle: RePEc:oup:rfinst:v:13:y:2000:i:2:p:433-51

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  1. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
  2. Melick, William R. & Thomas, Charles P., 1997. "Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(01), pages 91-115, March.
  3. Jens Carsten Jackwerth., 1996. "Implied Binomial Trees: Generalizations and Empirical Tests," Research Program in Finance Working Papers RPF-262, University of California at Berkeley.
  4. Ross, Stephen A, 1976. "Options and Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 90(1), pages 75-89, February.
  5. Joshua V. Rosenberg & Robert F. Engle, 1997. "Option Hedging Using Empirical Pricing Kernels," NBER Working Papers 6222, National Bureau of Economic Research, Inc.
  6. Brennan, M.J. & Solanki, R., 1981. "Optimal Portfolio Insurance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(03), pages 279-300, September.
  7. Yacine Aït-Sahalia & Andrew W. Lo, . "Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices," CRSP working papers 332, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Rubinstein, Mark E, 1973. "A Comparative Statics Analysis of Risk Premiums," The Journal of Business, University of Chicago Press, vol. 46(4), pages 605-15, October.
  9. Constantinides, George M, 1982. "Intertemporal Asset Pricing with Heterogeneous Consumers and without Demand Aggregation," The Journal of Business, University of Chicago Press, vol. 55(2), pages 253-67, April.
  10. Robert C. Merton, 1980. "On Estimating the Expected Return on the Market: An Exploratory Investigation," NBER Working Papers 0444, National Bureau of Economic Research, Inc.
  11. Mark Rubinstein, 1976. "The Valuation of Uncertain Income Streams and the Pricing of Options," Bell Journal of Economics, The RAND Corporation, vol. 7(2), pages 407-425, Autumn.
  12. Hayne E. Leland., 1979. "Who Should Buy Portfolio Insurance?," Research Program in Finance Working Papers 95, University of California at Berkeley.
  13. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December.
  14. Banz, Rolf W & Miller, Merton H, 1978. "Prices for State-contingent Claims: Some Estimates and Applications," The Journal of Business, University of Chicago Press, vol. 51(4), pages 653-72, October.
  15. Hayne E. Leland., 1996. "Beyond Mean-Variance: Performance Measurement of Portfolios Using Options or Dynamic Strategies," Research Program in Finance Working Papers RPF-263-rev, University of California at Berkeley.
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