Practical Applications of What Goes into Risk-Neutral Volatility? Empirical Estimates of Risk and Subjective Risk Preferences

Abstract

The Black–Scholes option-pricing model doesn’t work in the real world because option prices embed both the market’s estimate of the empirical returns distribution as well as investors’ risk attitudes. These influences are reflected in the risk-neutral probability distribution, which can be extracted from option prices without restrictive assumptions from a pricing model. In What Goes into Risk-Neutral Volatility? Empirical Estimates of Risk and Subjective Risk Preferences, published in the Fall 2016 issue of The Journal of Portfolio Management, Stephen Figlewski, professor of finance at NYU’s Stern School of Business, finds that risk-neutral volatility is strongly influenced by investors’ projections of future realized volatility and by the risk-neutralization process. Several significant variables, including the daily trading range and tail risk, are connected in different ways to realized volatility, while other variables reflect risk attitudes, such as the levels of consumer and investor confidence. This report and the original article will be of particular interest to investors and academics who seek to bridge the gap between theory and practice. TOPICS:Options, quantitative methods, tail risks