Option Implied Risk Aversion and Elasticity of Intertemporal Substitution

Abstract

We estimate both a time series of risk aversion and elasticity of intertemporal substitution (EIS) using option prices on the S&P 500, returns on the index, and the Epstein-Zin utility function. This is the first study to simultaneously estimate both a time series of risk aversion and EIS coefficients. Unlike many previous option implied risk aversion studies, we find positive and reasonable estimates of risk aversion. Further, we show that unexpected changes in risk aversion and EIS are both significantly related to changes in the market risk premium and with changes in the aggregate consumption-to-wealth ratio. Unanticipated changes in EIS are significantly related to changes in interest rates and market volatility. Our findings show the importance of disentangling the representative agent's risk aversion and EIS and the importance of modeling a changing representative agent.