Why does Implied Risk Aversion Smile?

Alexandre Ziegler
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Alexandre Ziegler: University of Lausanne and FAME

FAME Research Paper Series from International Center for Financial Asset Management and Engineering

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.

Keywords: asset pricing; state-price density; heterogeneous preferences; heterogeneous beliefs; implied risk aversion (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Date: 2002-05
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Citations: View citations in EconPapers (1)

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