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Uncovering the Distribution of Option Implied Risk Aversion

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Document pages: 24 pages

Abstract: This paper explores the dynamics of risk aversion of a representative agentwith an iso-elastic utility function. In contrast to most of the existing literature,we estimate the coefficient of relative risk aversion from option prices.To do this, we transform the risk-neutral density function obtained from across-section of option prices to an objective distribution function that reflectsindividuals’ risk aversion through a CRRA utility function. The dynamicsof the relative risk-aversion coefficient are obtained by repeating the sameestimation procedure over rolling windows. This procedure uncovers strongvariation in risk aversion over time. We also propose a simulation procedureto construct confidence intervals for the risk-aversion coefficient in each period.We assess the robustness of these confidence intervals under differentassumptions on the data generating process of stock prices. The results implya strong influence of volatility on the variation of risk aversion. In an empiricalapplication, we compare the forecasting performance of our approachbased on our risk-aversion estimates against the method proposed in [1].Overall, we find that our simulation based approach obtains better forecastingresults than bootstrap methods.

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