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Estimating Relative Risk Aversion, Risk-Neutral and Real-World Densities using Brazilian Real Currency Options

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  • Ornelas, Jose Renato Haas
  • Barbachan, José Fajardo
  • Farias, Aquiles Rocha de

Abstract

Building Risk-Neutral Densities (RND) from options data can provide market-impliedexpectations about the future behavior of a financial variable. And market expectations onfinancial variables may influence macroeconomic policy decisions. It can be useful also forcorporate and financial institutions decision making. This paper uses the Liu et all (2007)approach to estimate the option-implied Risk-neutral densities from the Brazilian Real/USDollar exchange rate distribution. We then compare the RND with actual exchange rates, ona monthly basis, in order to estimate the relative risk-aversion of investors and also obtain aReal-world density for the exchange rate. We are the first to calculate relative risk-aversionand the option-implied Real World Density for an emerging market currency. Our empiricalapplication uses a sample of Brazilian Real/US Dollar options traded at BM&F-Bovespafrom 1999 to 2011. The RND is estimated using a Mixture of Two Log-Normals distributionand then the real-world density is obtained by means of the Liu et al. (2007) parametric risktransformations.The relative risk aversion is calculated for the full sample. Our estimatedvalue of the relative risk aversion parameter is around 2.7, which is in line with other articlesthat have estimated this parameter for the Brazilian Economy, such as Araújo (2005) andIssler and Piqueira (2000). Our out-of-sample evaluation results showed that the RND hassome ability to forecast the Brazilian Real exchange rate. Abe et all (2007) found also mixedresults in the out-of-sample analysis of the RND forecast ability for exchange rate options.However, when we incorporate the risk aversion into RND in order to obtain a Real-worlddensity, the out-of-sample performance improves substantially, with satisfactory results inboth Kolmogorov and Berkowitz tests. Therefore, we would suggest not using the “pure”RND, but rather taking into account risk aversion in order to forecast the Brazilian Realexchange rate.

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Bibliographic Info

Paper provided by School of Public and Business Administration, Getulio Vargas Foundation (Brazil) in its series EBAPE Working Papers with number 1.

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Date of creation: 12 Apr 2012
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Handle: RePEc:fgv:ebapwp:1

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Cited by:
  1. Waldyr Areosa & Marta Areosa, 2012. "Information (in) Chains: information transmission through production chains," Working Papers Series 286, Central Bank of Brazil, Research Department.
  2. Bruno Martins, 2012. "Local Market Structure and Bank Competition: evidence from the Brazilian auto loan market," Working Papers Series 299, Central Bank of Brazil, Research Department.
  3. Angelo Marsiglia Fasolo, 2012. "A Note on Particle Filters Applied to DSGE Models," Working Papers Series 281, Central Bank of Brazil, Research Department.

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