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State Dependence Can Explain the Risk Aversion Puzzle

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  • Fousseni Chabi-Yo
  • René Garcia
  • Eric Renault

Abstract

Risk aversion functions extracted from observed stock and option prices can be negative, as shown by Aït-Sahalia and Lo (2000), Journal of Econometrics 94: 9--51; and Jackwerth (2000), The Review of Financial Studies 13(2), 433--51. We rationalize this puzzle by a lack of conditioning on latent state variables. Once properly conditioned, risk aversion functions and pricing kernels are consistent with economic theory. To differentiate between the various theoretical explanations in terms of heterogeneity of beliefs or preferences, market sentiment, state-dependent utility, or regimes in fundamentals, we calibrate several consumption-based asset pricing models to match the empirical pricing kernel and risk aversion functions at different dates and over several years. The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org., Oxford University Press.

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Bibliographic Info

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

Volume (Year): 21 (2008)
Issue (Month): 2 (April)
Pages: 973-1011

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Handle: RePEc:oup:rfinst:v:21:y:2008:i:2:p:973-1011

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  1. repec:wyi:wpaper:002033 is not listed on IDEAS
  2. repec:ebl:ecbull:v:30:y:2010:i:1:p:182-191 is not listed on IDEAS
  3. Fabozzi, Frank J. & Leccadito, Arturo & Tunaru, Radu S., 2014. "Extracting market information from equity options with exponential Lévy processes," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 125-141.
  4. Beare, Brendan K., 2011. "Measure preserving derivatives and the pricing kernel puzzle," Journal of Mathematical Economics, Elsevier, vol. 47(6), pages 689-697.
  5. Wolfgang Karl Härdle & Yarema Okhrin & Weining Wang, 2010. "Uniform confidence bands for pricing kernels," SFB 649 Discussion Papers SFB649DP2010-003, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  6. Luiz Vitiello & Ser-Huang Poon, 2014. "Non-monotonic pricing kernel and an extended class of mixture of distributions for option pricing," Review of Derivatives Research, Springer, vol. 17(2), pages 241-259, July.
  7. Fengler, Matthias & Hin, Lin-Yee, 2011. "Semi-nonparametric estimation of the call price surface under strike and time-to-expiry no-arbitrage constraints," Economics Working Paper Series 1136, University of St. Gallen, School of Economics and Political Science, revised May 2013.
  8. repec:wyi:wpaper:002038 is not listed on IDEAS
  9. Benzoni, Luca & Collin-Dufresne, Pierre & Goldstein, Robert S., 2011. "Explaining asset pricing puzzles associated with the 1987 market crash," Journal of Financial Economics, Elsevier, vol. 101(3), pages 552-573, September.
  10. Beare, Brendan K. & Schmidt, Lawrence, 2011. "An Empirical Test of Pricing Kernel Monotonicity," University of California at San Diego, Economics Working Paper Series qt5572n8pc, Department of Economics, UC San Diego.
  11. Polkovnichenko, Valery & Zhao, Feng, 2013. "Probability weighting functions implied in options prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 580-609.
  12. Rompolis, Leonidas S., 2010. "Retrieving risk neutral densities from European option prices based on the principle of maximum entropy," Journal of Empirical Finance, Elsevier, vol. 17(5), pages 918-937, December.
  13. Frederik Lundtofte, 2010. "Implied volatility and risk aversion in a simple model with uncertain growth," Economics Bulletin, AccessEcon, vol. 30(1), pages 182-191.
  14. Wolfgang Härdle & Volker Krätschmer & Rouslan Moro, 2009. "A Microeconomic Explanation of the EPK Paradox," SFB 649 Discussion Papers SFB649DP2009-010, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  15. Maria Grith & Wolfgang Karl Härdle & Volker Krätschmer, 2013. "Reference Dependent Preferences and the EPK Puzzle," SFB 649 Discussion Papers SFB649DP2013-023, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.

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