State Dependence Can Explain the Risk Aversion Puzzle

Posted: 26 Jun 2008

See all articles by Fousseni Chabi-Yo

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

René Garcia

Université de Montréal - CIREQ - Département de sciences économiques; University of Montreal

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics

Date Written: April 2008

Abstract

Risk aversion functions extracted from observed stock and option prices can be negative, as shown by Aït-Sahalia and Lo (2000), Journal of Econometrics 94: 9-51; and Jackwerth (2000), The Review of Financial Studies 13(2), 433-51. We rationalize this puzzle by a lack of conditioning on latent state variables. Once properly conditioned, risk aversion functions and pricing kernels are consistent with economic theory. To differentiate between the various theoretical explanations in terms of heterogeneity of beliefs or preferences, market sentiment, state-dependent utility, or regimes in fundamentals, we calibrate several consumption-based asset pricing models to match the empirical pricing kernel and risk aversion functions at different dates and over several years.

Keywords: G12, G13

Suggested Citation

Chabi-Yo, Fousseni and Garcia, René and Renault, Eric, State Dependence Can Explain the Risk Aversion Puzzle (April 2008). Review of Financial Studies, Vol. 21, Issue 2, pp. 973-1011, 2008, Available at SSRN: https://ssrn.com/abstract=1151591 or http://dx.doi.org/hhm070

Fousseni Chabi-Yo (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

René Garcia

Université de Montréal - CIREQ - Département de sciences économiques ( email )

C.P. 6128, succursale Centre-Ville
3150, rue Jean-Brillant, bureau C-6027
Montreal, Quebec H3C 3J7
Canada
514-985-4014 (Phone)

University of Montreal ( email )

United States

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

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