State Dependence Can Explain the Risk Aversion Puzzle
Posted: 26 Jun 2008
Date Written: April 2008
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: Suggested Citation