Option-Implied Risk-Neutral Distributions and Risk Aversion

Analysts are accustomed to using prices for the information they contain. A stock price, for example, can be thought of as an expected value of future cash flows. Each futures price and option price tells the analyst a bit more about the probability distribution under which those expectations should be accepted. These pieces of information provide the probability distribution of the price. In this Research Foundation monograph, Jens Jackwerth explains why for pricing purposes, the analyst uses the risk-neutral distribution and details the pitfalls of applying this distribution immediately for forecasting. Finally, the risk-neutral distributions can be compared with estimated actual distributions to uncover investor risk preferences. Jackwerth warns, however, of an empirical irregularity that is emerging: The risk-neutral distribution, the actual distribution, and the implied preferences are incompatible with each other.