State Dependence in Fundamentals and Preferences Explains Risk-Aversion Puzzle

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.

Also published as:

State dependence can explain the risk aversion puzzle
The Review of Financial Studies (0893-9454)
April 2008. Vol. 21, Iss. 2, p. 973-1011