Risk Propensity Surface

Abstract:     
Investor confidence as risk propensity is measured with the SDT (Signal Detection Theory) formula. This piece presents theoretical relationships between risk propensity, implied volatility, and strike price (X), illustrated as the risk propensity surface against volatility and price. Derived from the volatility smile of the Black Scholes model and the SDT formula for risk propensity, one may predict that (1) risk propensity increases as volatility increases given stable price; (2) risk propensity increases as strike price increases given stable volatility; (3) above the money strike price increases as volatility increases given stable risk propensity; (4) the risk propensity surface may explain the volatility smile. The strategy derived from the risk propensity surface may lead to the creation of new financial instruments that consider both behavioral (risk propensity as investor confidence) and quantitative (volatility) ingredients.

Keywords: Volatility, investor confidence, risk, choice modeling

JEL Classifications: G12, G13

Working Paper Series