Option-Implied Preference with Model Uncertainty

Abstract

We present a theoretical model of option-implied preferences with model uncertainty. An option-implied risk aversion function with model uncertainty has a higher and a steeper level of risk aversion than an investor without model uncertainty. Based on the theoretical model, we try to extract empirical option-implied risk aversion functions with S&P 500 index options. Our empirical option-implied risk aversion with model uncertainty and option-implied uncertainty premium show a decreasing and a smirk pattern across wealth. After subprime crisis, the shape of option-implied risk aversion function with model uncertainty is not quite different, and both the level of option-implied risk aversion function and the option-implied uncertainty premium become slightly lowered. (c) 2014 Wiley Periodicals, Inc. Jrl Fut Mark 34:498-515, 2014