Details
| Original language | English |
|---|---|
| Pages (from-to) | 1-35 |
| Number of pages | 35 |
| Journal | Review of derivatives research |
| Volume | 27 |
| Issue number | 1 |
| Early online date | 29 Nov 2023 |
| Publication status | Published - Apr 2024 |
Abstract
In order to estimate volatility-dependent probability weighting functions, we obtain risk neutral and physical densities from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) stochastic volatility and jumps model. Across volatility levels, we find pronounced inverse S-shapes, i.e. small probabilities are overweighted, and probability weighting almost monotonically increases in volatility, indicating higher skewness preferences and crash aversion in volatile market environments. Moreover, by estimating probabilistic risk attitudes, equivalent to the share of risk aversion related to probability weighting, we shed further light on the pricing kernel puzzle. While pricing kernels estimated from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) model display the typical U-shape as documented in the literature, pricing kernels—net of probability weighting—are strictly monotonically decreasing and thus in line with economic theory. Equivalently, we find risk aversion to be positive across wealth levels. Our results are robust to alternative maturities, wealth percentiles, alternative functional forms, a nonparametric empirical setting and variations of the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) coefficient estimates.
Keywords
- Pricing kernel puzzle, Probability weighting, Risk preferences, Volatility, G41, G11, G14
ASJC Scopus subject areas
- Economics, Econometrics and Finance(all)
- Economics, Econometrics and Finance (miscellaneous)
- Economics, Econometrics and Finance(all)
- Finance
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In: Review of derivatives research, Vol. 27, No. 1, 04.2024, p. 1-35.
Research output: Contribution to journal › Article › Research › peer review
}
TY - JOUR
T1 - Volatility-dependent probability weighting and the dynamics of the pricing kernel puzzle
AU - Dierkes, Maik
AU - Krupski, Jan
AU - Schroen, Sebastian
AU - Sibbertsen, Philipp
N1 - Open Access funding enabled and organized by Projekt DEAL.
PY - 2024/4
Y1 - 2024/4
N2 - In order to estimate volatility-dependent probability weighting functions, we obtain risk neutral and physical densities from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) stochastic volatility and jumps model. Across volatility levels, we find pronounced inverse S-shapes, i.e. small probabilities are overweighted, and probability weighting almost monotonically increases in volatility, indicating higher skewness preferences and crash aversion in volatile market environments. Moreover, by estimating probabilistic risk attitudes, equivalent to the share of risk aversion related to probability weighting, we shed further light on the pricing kernel puzzle. While pricing kernels estimated from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) model display the typical U-shape as documented in the literature, pricing kernels—net of probability weighting—are strictly monotonically decreasing and thus in line with economic theory. Equivalently, we find risk aversion to be positive across wealth levels. Our results are robust to alternative maturities, wealth percentiles, alternative functional forms, a nonparametric empirical setting and variations of the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) coefficient estimates.
AB - In order to estimate volatility-dependent probability weighting functions, we obtain risk neutral and physical densities from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) stochastic volatility and jumps model. Across volatility levels, we find pronounced inverse S-shapes, i.e. small probabilities are overweighted, and probability weighting almost monotonically increases in volatility, indicating higher skewness preferences and crash aversion in volatile market environments. Moreover, by estimating probabilistic risk attitudes, equivalent to the share of risk aversion related to probability weighting, we shed further light on the pricing kernel puzzle. While pricing kernels estimated from the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) model display the typical U-shape as documented in the literature, pricing kernels—net of probability weighting—are strictly monotonically decreasing and thus in line with economic theory. Equivalently, we find risk aversion to be positive across wealth levels. Our results are robust to alternative maturities, wealth percentiles, alternative functional forms, a nonparametric empirical setting and variations of the Pan (J Financ Econ 63(1):3–50, 2002. https://doi.org/10.1016/S0304-405X(01)00088-5) coefficient estimates.
KW - Pricing kernel puzzle
KW - Probability weighting
KW - Risk preferences
KW - Volatility
KW - G41
KW - G11
KW - G14
UR - http://www.scopus.com/inward/record.url?scp=85177745404&partnerID=8YFLogxK
U2 - 10.1007/s11147-023-09197-3
DO - 10.1007/s11147-023-09197-3
M3 - Article
AN - SCOPUS:85177745404
VL - 27
SP - 1
EP - 35
JO - Review of derivatives research
JF - Review of derivatives research
SN - 1380-6645
IS - 1
ER -