Recovering Risk Aversion from Option Prices and Realized Returns
Paper No. 47
20 Pages Posted: 9 Sep 1996
Date Written: July 23, 1998
A relationship exists between aggregate risk-neutral and subjective probability distributions and risk aversion functions. We empirically derive risk aversion functions implied by option prices and realized returns on the S&P 500 index simultaneously. These risk aversion functions dramatically change shapes around the 1987 crash: Precrash, they are positive and decreasing in wealth and largely consistent with standard economic theory. Postcrash, they are partially negative and partially increasing and irreconcilable with the theory. Mispricing in the option market is the most likely cause. A simulated trading strategy exploiting this mispricing shows excess returns even after accounting for the possibility of further crashes, transaction costs, and hedges against the downside risk.
JEL Classification: G13, G11
Suggested Citation: Suggested Citation