Option-implied risk preferences: An extension to wider classes of utility functions [An article from: Journal of Financial Markets]

This digital document is a journal article from Journal of Financial Markets, published by Elsevier in 2006. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

Description:
Investors' risk aversion functions can be derived from the risk neutral probability density functions (RN-PDFs) and an assumed well-behaved functional form for the utility function. This paper extends the analysis to more general cases by assuming wider classes of utility functions. Using FTSE 100 index options, we evaluate the forecasting ability of RN-PDFs and subjective PDFs with five assumed utility functions and then derive the corresponding option-implied risk aversion functions. From our empirical analysis, we find that: (1) assuming more flexible utility functions generally increases the forecasting ability of the derived subjective PDFs; and (2) the measure of relative risk aversion is significantly different from zero and decreases across wealth. These results essentially hold regardless of forecast horizon. Out of sample tests also confirm the robustness of our findings.