Why Does Implied Risk Aversion Smile?

FAME Research Paper No. 47

41 Pages Posted: 25 Mar 2003

See all articles by Alexandre Ziegler

Alexandre Ziegler

University of Zurich - Department of Banking and Finance

Date Written: May 2002


A few recent papers have derived estimates of the representative agent's risk aversion by comparing the statistical density of asset returns and the state-price density. The implied risk aversion estimates obtained in these studies are puzzling, exhibiting (i) pronounced U-shaped patterns (a "smile") and (ii) negative values. This paper analyzes three potential explanations for these phenomena: (i) heterogeneity in investor preferences, (ii) difficulties in estimating agents' beliefs and (iii) heterogeneous beliefs among agents. Our results show that preferences alone cannot explain the patterns reported in the literature. Misestimation of investors' beliefs caused by nonstationarity of the return process cannot explain the smile either. The patterns of beliefs misestimation required to generate the empirical implied risk aversion estimates found in the literature suggest that heterogeneous beliefs are the most likely cause of the smile.

Keywords: asset pricing, state-price density, heterogeneous preferences, heterogeneous beliefs, implied risk aversion

JEL Classification: G12, G13

Suggested Citation

Ziegler, Alexandre, Why Does Implied Risk Aversion Smile? (May 2002). FAME Research Paper No. 47, Available at SSRN: https://ssrn.com/abstract=372021 or http://dx.doi.org/10.2139/ssrn.372021

Alexandre Ziegler (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

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