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Recovering risk aversion from options

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Author Info
Robert R. Bliss
Nikolaos Panigirtzoglou
Abstract

Cross-sections of option prices embed the risk-neutral probability densities functions (PDFs) for the future values of the underlying asset. Theory suggests that risk-neutral PDFs differ from market expectations due to risk premia. Using a utility function to adjust the risk-neutral PDF to produce subjective PDFs, we can obtain measures of the risk aversion implied in option prices. Using FTSE 100 and S&P 500 options, and both power and exponential utility functions, we show that subjective PDFs accurately forecast the distribution of realizations, while risk-neutral PDFs do not. The estimated coefficients of relative risk aversion are all reasonable. The relative risk aversion estimates are remarkably consistent across utility functions and across markets for given horizons. The degree of relative risk aversion declines with the forecast horizon and is lower during periods of high market volatility.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-01-15.

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Date of creation: 2001
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Handle: RePEc:fip:fedhwp:wp-01-15

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Keywords: Options (Finance) ; Prices;

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  15. Bartunek, Kenneth S & Chowdhury, Mustafa, 1997. "Implied Risk Aversion Parameter from Option Prices," The Financial Review, Eastern Finance Association, vol. 32(1), pages 107-24, February.
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  1. Andersson, Magnus & Lomakka, Magnus, 2003. "Evaluating Implied RNDs by some New Confidence Interval Estimation Techniques," Working Paper Series 146, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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