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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.

Suggested Citation

  • Fousseni Chabi-Yo & René Garcia & Eric Renault, 2008. "State Dependence Can Explain the Risk Aversion Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 973-1011, April.
  • Handle: RePEc:oup:rfinst:v:21:y:2008:i:2:p:973-1011
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    9. Wu, Feng & Myers, Robert J. & Guan, Zhengfei & Wang, Zhiguang, 2015. "Risk-adjusted implied volatility and its performance in forecasting realized volatility in corn futures prices," Journal of Empirical Finance, Elsevier, pages 260-274.
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    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, pages 918-937.
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    15. Fousseni Chabi-Yo, 2012. "Pricing Kernels with Stochastic Skewness and Volatility Risk," Management Science, INFORMS, pages 624-640.
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    23. 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.
    24. Frederik Lundtofte, 2010. "Implied volatility and risk aversion in a simple model with uncertain growth," Economics Bulletin, AccessEcon, vol. 30(1), pages 182-191.

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