Risk Adjustment and the Temporal Resolution of Uncertainty: Evidence from Options Markets

42 Pages Posted: 19 Sep 2014

See all articles by Darien Huang

Darien Huang

Cornell University - Department of Finance

Ivan Shaliastovich

University of Wisconsin - Madison

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

Huang, Darien and Shaliastovich, Ivan, Risk Adjustment and the Temporal Resolution of Uncertainty: Evidence from Options Markets (May 1, 2014). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=2497756 or http://dx.doi.org/10.2139/ssrn.2497756

Darien Huang (Contact Author)

Cornell University - Department of Finance ( email )

Ithaca, NY 14853-4201
United States

Ivan Shaliastovich

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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