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Recovering Probabilities and Risk Aversion from Option Prices and Realized Returns

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  • Jackwerth, Jens Carsten
  • Rubinstein, Mark

Abstract

This paper summarizes a program of research we have conducted over the past four years. So far, it has produced two published articles, one forthcoming paper, one working paper currently under review at a journal, and three working papers in progress. The research concerns the recovery of market-wide risk-neutral probabilities and risk aversion from option prices. The work is built on the idea that risk-neutral probabilities (or their related state-contingent prices) are an amalgam of consensus subjective probabilities and consensus risk aversion. The most significant departure of this work is that it reverses the normal direction of previous research, which typically moves from assumptions governing subjective probabilities and risk aversion, to conclusions about risk-neutral probabilities. Our work is partially motivated by the conspicuous failure of the Black-Scholes formula to explain the prices of index options in the post-1987 crash market. First, we independently estimate risk-neutral probabilities, taking advantage of the now highly liquid index option market. We show that, if the options market is free of general arbitrage opportunities and we can at least initially ignore trading costs, there are quite robust methods for recovering these probabilities. Second, with these probabilities in hand, we use the method of implied binomial trees to recover a consistent stochastic process followed by the underlying asset price. Third, we provide an empirical test of implied trees against alternative option pricing models (including “naïve trader” approaches) by using them to forecast future option smiles. Fourth, we argue that realized historical distributions will be a reliable proxy for certain aspects of the true subjective distributions. We then use these observed aspects together with the option-implied risk-neutral probabilities to estimate market-wide risk aversion.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11638.

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Date of creation: 2003
Date of revision: 2004
Handle: RePEc:pra:mprapa:11638

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Related research

Keywords: Risk Aversion; Option; Realized Returns;

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References

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  1. Jens Carsten Jackwerth., 1996. "Generalized Binomial Trees," Research Program in Finance Working Papers RPF-264, University of California at Berkeley.
  2. Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  4. Jens Carsten Jackwerth, 1998. "Recovering Risk Aversion from Option Prices and Realized Returns," Finance 9803002, EconWPA.
  5. 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.
  6. 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.
  7. Rubinstein, Mark, 1983. " Displaced Diffusion Option Pricing," Journal of Finance, American Finance Association, vol. 38(1), pages 213-17, March.
  8. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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Cited by:
  1. Fousseni Chabi-Yo & René Garcia & Eric Renault, 2005. "State Dependence in Fundamentals and Preferences Explains Risk-Aversion Puzzle," Working Papers 05-9, Bank of Canada.
  2. Wael Bahsoun & Pawel Góra & Silvia Mayoral & Manuel Morales, . "Random Dynamics and Finance: Constructing Implied Binomial Trees from a Predetermined Stationary Den," Faculty Working Papers 13/06, School of Economics and Business Administration, University of Navarra.
  3. René Garcia & Eric Ghysels & Éric Renault, 2004. "The Econometrics of Option Pricing," CIRANO Working Papers 2004s-04, CIRANO.
  4. Lüders, Erik, 2002. "Asset Prices and Alternative Characterizations of the Pricing Kernel," ZEW Discussion Papers 02-10, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.

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