Journal Article

State Dependence Can Explain the Risk Aversion Puzzle

Fousseni Chabi-Yo, René Garcia and Eric Renault

in The Review of Financial Studies

Published on behalf of The Society for Financial Studies

Volume 21, issue 2, pages 973-1011
Published in print April 2008 | ISSN: 0893-9454
Published online December 2007 | e-ISSN: 1465-7368 | DOI: https://dx.doi.org/10.1093/rfs/hhm070
State Dependence Can Explain the Risk Aversion Puzzle

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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

Journal Article.  15480 words.  Illustrated.

Subjects: Economics

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