Evolution of risk aversion through time, causes and consequences

Abstract

Risk aversion has been treated by traditional finance as a stable input that was more useful to match the investors’ needs than a real driver for the financial markets. With the development of behavioural finance, some analysts tried to use this metric to improve their predictions over the markets. However, risk aversion is hard to aggregate. Most early attempts to find a relevant risk aversion of the market as a whole failed. In the early 2000’s, researchers started focusing on the derivatives markets to improve the measurement of the representative investor’s attitude toward risk. Since hedges are possible over options, they can be used to create risk-neutral market expectations at a maturity. These expectations can be interpreted as probability density function by using different processes. Once these risk neutral density functions are created, it can be compared to the actual view of the representative investor over the market at the same maturity. The variation between the risk-neutral and the subjective densities can be interpreted as a proxy of the marginal rate of substitution at maturity. From this relation, the relative risk aversion of the market can be calculated. Unfortunately, the process to create the risk neutral density requires consequent amount of data. In this thesis, the focus is done on the creation of a coefficient that can be computed with less statistics. The information is not processed from every option price but from the implied volatility index of an underlying market index. Distribution is parametrized, and the risk aversion can be computed with only two variables per date. However, this simplification is lowering the accuracy of the created coefficient. In the second part of the thesis, the explanatory power of the simplified metric is evaluated through linear regressions. The goal is to assess the impact of the simplification process. The results are mixed. The created coefficients are able to explain a significant part of the returns of the index. But more could have been expected regarding the fact that this risk aversion metric is using ex-post information.