Risk aversion, fanning preference and volatility smirk on S&P 500 index options

Jian Chen and Chenghu Ma

Applied Economics, 2016, vol. 48, issue 35, 3277-3292

Abstract: This article proposes a novel way of pricing S&P 500 index options in the presence of jump risk. Our analysis is built upon an equilibrium option pricing rule for a representative agent economy. In particular, we use the weighted utility’s certainty equivalent to specify agent’s risk preference, which displays a fanning-out characteristic. We find that the fanning effect captures a remarkably large portion of the total market risk premium implicit in options. As a result, the model with fanning effect generates pronounced volatility smirks.

Date: 2016
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DOI: 10.1080/00036846.2015.1137548

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