State Dependence in Fundamentals and Preferences Explains Risk-Aversion Puzzle

Fousseni Chabi-Yo, René Garcia and Eric Renault

Staff Working Papers from Bank of Canada

Abstract: The authors examine the ability of economic models with regime shifts to rationalize and explain the risk-aversion and pricing-kernel puzzles put forward in Jackwerth (2000). They build an economy where investors' preferences or economic fundamentals are state-dependent, and simulate prices for a market index and European options on that index. Based on the original nonparametric methodology, the risk-aversion and pricing-kernel functions obtained across wealth states with these artificial data exhibit the same puzzles found with the actual data, but within each regime the puzzles disappear. This suggests that state dependence potentially explains the puzzles.

Keywords: Financial markets; Market structure and pricing (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2005
New Economics Papers: this item is included in nep-bec, nep-cmp, nep-fin and nep-rmg
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