Risk Adjustment and the Temporal Resolution of Uncertainty: Evidence from Options Markets
42 Pages Posted: 19 Sep 2014
Date Written: May 1, 2014
Abstract
Risk-neutral probabilities, observable from option prices, combine objective probabilities and risk adjustments across economic states. We consider a recursive-utility framework to separately identify objective probabilities and risk adjustments using only observed market prices. We find that a preference for early resolution of uncertainty plays a key role in generating sizeable risk premia to explain the cross-section of risk-neutral and objective probabilities in the data. Failure to incorporate a preference for the timing of the resolution of uncertainty (e.g., expected utility models) can significantly overstate the implied probability of, and understate risk compensations for, adverse economic states.
Keywords: asset pricing, risk-neutral probabilities, options
JEL Classification: G12, D81
Suggested Citation: Suggested Citation