RFS Advance Access originally published online on December 17, 2007
Review of Financial Studies 2008 21(2):973-1011; doi:10.1093/rfs/hhm070
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State Dependence Can Explain the Risk Aversion Puzzle
Bank of Canada
Edhec Business School
University of North Carolina at Chapel Hill, CIREQ and CIRANO
Address correspondence to René Garcia, Edhec Business School, 393. Promenade des Anglais, BP3116, 06202 Nice Cedex 3, France, telephone: +33493187802; e-mail: rene.garcia{at}edhec.edu.
JEL Classification: G12, G13
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Abstract |
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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.
We thank two anonymous referees and the editor (Yacine Ait-Sahalia) for useful comments. We also thank Jens Carsten Jackwerth for kindly providing us with the data used in the empirical section. The authors gratefully acknowledge financial support from the Fonds Québecois de Recherche sur la Société et la Culture (FQRSC), the Social Sciences and Humanities Research Council of Canada (SSHRC), and the Network of Centres of Excellence MITACS. The second author is a CIRANO and CIREQ research fellow; he is grateful to Hydro-Quebec and the Bank of Canada Fellowship for financial support. The views expressed in this article are those of the authors. No responsibility for them should be attributed to the Bank of Canada.