Can Loss Aversion Explain the Stylized Facts of Implied Volatility?

34 Pages Posted: 7 Jun 2023

See all articles by Valeriy Zakamulin

Valeriy Zakamulin

University of Agder - School of Business and Law

Date Written: June 7, 2023

Abstract

The empirical literature has extensively documented several notable features of implied volatility. These features encompass the presence of a smirk shape, a term structure pattern, as well as volatility and skewness risk premia. The theoretical literature suggests that preference-free option pricing models can account for the smirk shape and term structure pattern, but they are unable to explain the existence of volatility and skewness risk premia. In contrast, utility-based option pricing models can produce these two risk premia, given specific conditions such as non-normality in stock returns, heterogeneity among investors, or the presence of investors who adhere to the conventional utility function in prospect theory, which entails a subjective distortion of objective probabilities. This paper examines the role of loss aversion in explaining the stylized facts of implied volatility. Our approach involves assuming that the representative investor in the market possesses a versatile utility function capable of expressing different preferences for losses and gains. The option prices are determined using an equilibrium argument. Our main finding is that loss aversion alone can explain all stylized facts of implied volatility and produce substantial volatility and skewness risk premia even when stock returns follow a normal distribution.

Keywords: loss aversion, implied volatility, volatility risk premium, skewness risk premium

JEL Classification: G11, G12, G13

Suggested Citation

Zakamulin, Valeriy, Can Loss Aversion Explain the Stylized Facts of Implied Volatility? (June 7, 2023). Available at SSRN: https://ssrn.com/abstract=4471421 or http://dx.doi.org/10.2139/ssrn.4471421

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University of Agder - School of Business and Law ( email )

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