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Why does Implied Risk Aversion Smile?

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  • Alexandre Ziegler

    (University of Lausanne and FAME)

Abstract

A few recent papers have derived estimates of the representative agent's risk aversion by comparing the statistical density of asset returns and the state-price density. The implied risk aversion estimates obtained in these studies are puzzling, exhibiting (i) pronounced U-shaped patterns (a "smile") and (ii) negative values. This paper analyzes three potential explanations for these phenomena: (i) heterogeneity in investor preferences, (ii) difficulties in estimating agents' beliefs and (iii) heterogeneous beliefs among agents. Our results show that preferences alone cannot explain the patterns reported in the literature. Misestimation of investors' beliefs caused by nonstationarity of the return process cannot explain the smile either. The patterns of beliefs misestimation required to generate the empirical implied risk aversion estimates found in the literature suggest that heterogeneous beliefs are the most likely cause of the smile.

Suggested Citation

  • Alexandre Ziegler, 2002. "Why does Implied Risk Aversion Smile?," FAME Research Paper Series rp47, International Center for Financial Asset Management and Engineering.
    • Handle: RePEc:fam:rpseri:rp47
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    File URL: http://www.swissfinanceinstitute.ch/rp47.pdf
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    References listed on IDEAS

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    Cited by:

    1. Daniel Giamouridis, 2005. "Inferring option-implied investors' risk preferences," Applied Financial Economics, Taylor & Francis Journals, vol. 15(7), pages 479-488.

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    More about this item

    Keywords

    asset pricing; state-price density; heterogeneous preferences; heterogeneous beliefs; implied risk aversion;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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