Recovering Risk Aversion from Option Prices and Realized Returns

Jens Jackwerth ()

Finance from EconWPA

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.

JEL-codes: G (search for similar items in EconPapers)
Date: Written
Note: Revision, October 1997; postscript
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Related works:
Working Paper: Recovering Risk Aversion from Option Prices and Realized Returns (1996)
Journal Article: Recovering Risk Aversion from Option Prices and Realized Returns (2000)
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:9803002

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