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Recovering Risk Aversion from Option Prices and Realized Returns

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  • Jens Carsten Jackwerth

    (Haas School of Business, University of California, Berkeley)

Abstract

A relationship exists between aggregate risk-neutral and subjective probability distributions and risk aversion functions. Using a variation of the method developed by Jackwerth and Rubinstein (1996), we estimate risk-neutral probabilities reliably from option prices. Subjective probabilities are estimated from realized returns. This paper then introduces a technique to empirically derive risk aversion functions implied by option prices and realized returns simultaneously. These risk aversion functions dramatically change shapes around the 1987 crash: Precrash, they are positive and decreasing in wealth and thus consistent with standard economic theory. Postcrash, they are partially negative and increasing and irreconcilable with the theory. Overpricing of out-of-the-money puts is the most likely cause. A simulated trading strategy exploiting this overpricing shows excess returns even after accounting for the possibility of further crashes and transaction costs.

Suggested Citation

  • Jens Carsten Jackwerth, 1998. "Recovering Risk Aversion from Option Prices and Realized Returns," Finance 9803002, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:9803002
    Note: Revision, October 1997; postscript
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    References listed on IDEAS

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    1. Brennan, M.J. & Solanki, R., 1981. "Optimal Portfolio Insurance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(3), pages 279-300, September.
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    4. Jens Carsten Jackwerth., 1996. "Implied Binomial Trees: Generalizations and Empirical Tests," Research Program in Finance Working Papers RPF-262, University of California at Berkeley.
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