The Implied Risk Aversion from Utility Indifference Option Pricing in a Stochastic Volatility Model
International Journal of Applied Mathematics & Statistics, Vol. 16, No. M10, pp. 11-37, March 2010
27 Pages Posted: 11 Oct 2009 Last revised: 25 Nov 2009
Date Written: October 8, 2009
The academic interest in utility indifference based approaches to derivative pricing in incomplete markets has grown during the last decades. In lack of arbitrage arguments the fair price of an option can be found through the value function of two optional investment choices, one where an option is issued and one where the wealth is invested directly in the underlying asset. In this paper we consider a stochastic volatility model deﬁned as a positive non-Gaussian Ornstein-Uhlenbeck process, and price call and put options using the indifference methodology in the case of exponential utility. The purpose of the study is to investigate empirically the implied risk aversion for a representative agent in the option market, as a function of time to maturity and strike price. Our study is based on real price data, calibrating the stochastic volatility model using historical price returns. The implied risk aversion is found by numerically inverting the indifference pricing equation, given observed option prices. We ﬁnd that the option prices in the market are basically set by the issuer, in the sense that it is the issuer’s indifference prices that matches the market prices. Since the stochastic volatility model explains the stylized facts of returns rather well, we expect the implied risk aversion to be close to ﬂat with respect to maturity and strike price of the options. We ﬁnd on the contrary a clear smile effect for short dated options, which may be explained by the issuer’s fear of a market crash (in the case of the issuance of a put option). Although the stochastic volatility model explains the heavy tails of the returns, the crash risk seems to be unexplained by the stochastic volatility model.
Keywords: stochastic volatility, utility indifference option pricing, risk aversion, Lévy processes
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