Risk aversion in financial crises

Abstract

This study is designed to understand how investors risk preferences change, when faced by financial crisis. Option prices implied densities provide information about market movements and risk preferences. The data used are European call options prices on the DJIA with a time to maturity of four weeks. This paper obtains the risk aversion estimates by the extraction of options implied risk neutral densities and their translation to real world densities, applied to three crisis : Dotcom bubble in 2001; Subprime mortgage in 2008 and European sovereign debt in 2011. RND is achieved by the use of two parametric methods: mixture of lognormal densities (MLN); and generalised beta distribution of the second kind (GB2). The risk transformation procedure from RND to RWD (real world densities) is achieved by applying the power utility function. The RND empirical results imply that the GB2 method is disregarded due to inferior quality whilst the MLN produces results of higher uncertainty and expected future results of index levels corrected downward. The risk aversion estimates obtained from the RWD generation process do not present any evident pattern of evolution from a stable financial period to one of financial shock. It is also important to mention that for some periods the risk aversion reached negative values. This is a surprising result due to existent theoretical assumption of positive risk aversion. Overall, this study documents inconclusive results. Nevertheless, several important topics are left for future research. Interesting developments would consist: either replicating this study considering more expiration dates, bearing in mind that too many periods would imply an extremely generalised risk aversion estimate that would be counterproductive for achieving the objective of this paper; apply another method from the available literature; or testing the negative estimates with more sophisticated models that are beyond the focus of this paper.

Date of Award	27 Jun 2013
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Joni Kokkonen (Supervisor)