Estimating Preferences Toward Risk: Evidence from Dow Jones

Abstract

What do investor utility functions look like? We show how returns on a stock and prices of call options written on that stock can be used jointly to recover utility of wealth function of the marginal investor in the stock. We study whether non-standard preferences have an impact sufficiently large that it is present in the stock prices. Using options on the stocks in the Dow Jones Index, we show support for non-concave utility functions with reference points proposed by Kahneman and Tversky, Friedman and Savage, and Markowitz. The evidence for Kahneman and Tversky Prospect Theory value function, and Friedman and Savage and Markowitz utility functions is much stronger than the support for the standard concave utility function. Together the utility functions with convex regions and with reference points account for 80% of the market capitalization of the sample stocks. This is the first study to report findings of these utility functions using the prices of individual stocks (nonexperimental data). We also investigate a closely related question of whether different assets reflect different risk preferences. We find evidence showing that different stocks reflect different types of investor utility function.

Keywords: Utility function, Investor risk preferences, Risk aversion, Risk seeking, Reference-Dependent

JEL Classification: D01, G11, G12