Risk preferences implied by synthetic options - Ian Dew-Becker
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Finance
Speaker : Ian Dew-Becker (Kellogg)
A large literature nds that equity index options are overpriced in the historical data (starting in the 1980s), earning low returns and strongly negative alphas. In a representative agent framework, that fact implies that marginal utility is convex relative to stock market wealth { risk aversion rises as wealth falls. This paper provides novel evidence on risk aversion and the shape of marginal utility using nearly a century of data on synthetic options, constructed from dynamic portfolios of the market and the riskless asset. In contrast to exchange-traded options, synthetic options show no evidence of overpricing (i.e., of negative alpha), and, therefore, no evidence of risk aversion rising as wealth falls. The divergence in results between listed and synthetic options can be explained by segmentation in the derivatives market, due to regulatory constraints and illiquidity. As those constraints have relaxed in the past 10{20 years, the returns on listed options have converged to those on synthetic options.