Option Pricing Under Time-Varying Risk-Aversion with Applications to Risk Forecasting

54 Pages Posted: 3 Oct 2015

See all articles by Ruediger Kiesel

Ruediger Kiesel

University of Duisburg-Essen - Faculty of Economic Science

Florentin Rahe

University of Ulm

Date Written: October 2, 2015

Abstract

We present a new option-pricing model, which explicitly captures the difference in the persistence of volatility under historical and risk-neutral probabilities. The model also allows to capture the empirical properties of pricing kernels, such as time-variation and the typical S-shape. We apply our model for two purposes. First, we analyze the risk preferences of market participants invested in S&P 500 index options during 2001-2009. We find that risk-aversion strongly increases during stressed market conditions and relaxes during normal market conditions. Second, we extract forward-looking information from S&P 500 index options and perform out-of-sample Value-at-Risk (VaR) forecasts during the period of the subprime mortgage crises. We compare the VaR forecasting performance of our model with four alternative VaR models and find that 2-Factor Stochastic Volatility models have the best forecasting performance.

Keywords: Pricing kernel, Option pricing, Implied risk premium, Value-at-Risk forecast

JEL Classification: G12, G13, G14

Suggested Citation

Kiesel, Ruediger and Rahe, Florentin, Option Pricing Under Time-Varying Risk-Aversion with Applications to Risk Forecasting (October 2, 2015). Available at SSRN: https://ssrn.com/abstract=2668542 or http://dx.doi.org/10.2139/ssrn.2668542

Ruediger Kiesel (Contact Author)

University of Duisburg-Essen - Faculty of Economic Science ( email )

Essen, 45117
Germany

HOME PAGE: http://www.lef.wiwi.uni-due.de/

Florentin Rahe

University of Ulm ( email )

Helmholtzstraße 16
Ulm, 89081
Germany

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