Option-implied risk preferences: An extension to wider classes of utility functions

Abstract

Investors' risk aversion functions can be derived from the risk neutral probability density functions (RN-PDFs) and an assumed well-behaved functional form for the utility function. This paper extends the analysis to more general cases by assuming wider classes of utility functions. Using FTSE 100 index options, we evaluate the forecasting ability of RN-PDFs and subjective PDFs with five assumed utility functions and then derive the corresponding option-implied risk aversion functions. From our empirical analysis, we find that: (1) assuming more flexible utility functions generally increases the forecasting ability of the derived subjective PDFs; and (2) the measure of relative risk aversion is significantly different from zero and decreases across wealth. These results essentially hold regardless of forecast horizon. Out of sample tests also confirm the robustness of our findings. (c) 2006 Elsevier B.V. All rights reserved.