Estimating Time-Varying Risk Aversion from Option Prices and Realized Returns
32 Pages Posted: 4 Apr 2022
Date Written: March 14, 2022
Abstract
We combine risk-neutral densities from equity index options with realized index returns to estimate the market's risk aversion. Starting from a power utility framework with constant risk aversion, we extend it by more flexible stochastic discount factors. We allow for time-varying risk aversion of the marginal investor, and we base our estimation as much as possible on forward-looking information. While the levels of the resulting estimates for risk aversion and expected returns are in line with the literature, we find the pricing kernel puzzle to be only an intermittent phenomenon, and our results point to pro-cyclical risk aversion.
Keywords: Stochastic discount factor, Pricing kernel puzzle, Time-varying risk aversion
JEL Classification: G13, D81
Suggested Citation: Suggested Citation