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Option pricing under time-varying risk-aversion with applications to risk forecasting

Rüdiger Kiesel and Florentin Rahe

Journal of Banking & Finance, 2017, vol. 76, issue C, 120-138

Abstract: We present a two-factor option-pricing model, which parsimoniously captures the difference in volatility persistences under the historical and risk-neutral probabilities. The model generates an S-shaped pricing kernel that exhibits time-varying risk aversion. We apply our model for two purposes. First, we analyze the risk preference implied by S&P500 index options during 2001–2009 and find that risk-aversion level strongly increases during stressed market conditions. Second, we apply our model for Value-at-Risk (VaR) forecasts during the subprime crisis period and find that it outperforms several leading VaR models.

Keywords: Pricing kernel; Option pricing; Implied risk premium; Value-at-Risk forecast (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 (search for similar items in EconPapers)
Date: 2017
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Handle: RePEc:eee:jbfina:v:76:y:2017:i:c:p:120-138