Option pricing with random risk aversion

Based on a standard general equilibrium economy, we develop a framework for pricing European options where the risk aversion parameter is state dependent, and aggregate wealth and the underlying asset have a bivariate transformed-normal distribution. Our results show that the volatility and the skewness of the risk aversion parameter change the slope of the pricing kernel, and that, as the volatility of the risk aversion parameter increases, the (Black and Scholes) implied volatility shifts upwards but its shape remains the same, which implies that the volatility of the risk aversion parameter does not change the shape of the risk neutral distribution. Also, we demonstrate that the pricing kernel may become non-monotonic for high levels of volatility and low levels of skewness of the risk aversion parameter. An empirical example shows that the estimated volatility of the risk aversion parameter tends to be low in periods of high market volatility and vice-versa.

Optimal Asset Allocation for CRRA and CARA Insurers under the Vasicek Interest Rate Model

This paper considers the reinsurance-investment problem with interest rate risks under constant relative risk aversion and constant absolute risk aversion preferences, respectively. Stochastic control theory and dynamic programming principle are applied to investigate the optimal proportional reinsurance-investment strategy for an insurer under the Vasicek stochastic interest rate model. Solving the corresponding Hamilton-Jacobi-Bellman equation via the Legendre transform approach, the optimal premium allocation strategies maximizing the expected utilities of terminal wealth are derived. In addition, several sensitivity analyses and numerical illustrations are given to analyze the impacts of different risk preferences and interest rate fluctuation on the optimal strategies. We find that the asset allocation and reinsurance ratio of the insurer are correlated with risk preference coefficient and interest rate fluctuation, and the insurance company may adjust the reinsurance-investment strategy to deal with interest rate risk.

Risk Aversion and Timber Harvest Strategies: A Case Study of Nonindustrial Private Forest Management in Louisiana

Forest owners face many challenges regarding forest management due to the long period from planting to harvest. Along with the economic and environmental factors that influence management actions, the owners' attitude to risk plays a crucial role in forest management decisions. This study shows that understanding the effects of the owner's risk preference for management actions is an important step to form an effective forest policy. The objectives of the study are to (1) assess the economic advantage of forest management alternatives over a range of risk aversion coefficients and (2) determine the financial incentive (risk premium) corresponding to a forest owners' risk attitude. We implemented the stochastic efficiency with respect to a function framework to evaluate a set of fertilization, herbicide, and thinning management alternatives at mid-rotation loblolly pine plantations in Louisiana. Results from this study indicate that forest owner's risk preference affects their decision to select management actions. Financial incentives are substantially different for specific management alternatives between risk-neutral and risk-averse forest owners. The results can guide forest policy development where agencies can modify financial assistance programs to improve the adoption of management actions.

A new behavioral finance mean variance framework

PurposeThe author proposes an update to the mean variance (MV) framework that replaces a constant risk aversion parameter using a dynamic risk aversion indicator. The contribution to the literature is made through making the static risk aversion parameter operational using an indicator of market sentiment. Results suggest that Sharpe ratios improve when the author replaces the traditional risk aversion parameter with a dynamic sentiment indicator from the behavioral finance literature when allocating between a risky portfolio and a risk-free asset. However, results are mixed when using the behavioral framework to allocate between two risky assets.Design/methodology/approachThe author includes a dynamic risk aversion parameter in the mean variance framework and back test using the traditional and updated behavioral mean variance (BMV) framework to see which framework leads to better performance.FindingsThe author finds that the behavioral framework provides superior performance when allocating between a risky and risk-free asset; however, it under performs when allocating between risky assets.Research limitations/implicationsThe research is based on back testing; therefore, it cannot be concluded that this strategy will perform well in real-time circumstances.Practical implicationsPortfolio managers may use this strategy to optimize the allocation between a risky portfolio and a risk-free asset.Social implicationsAn improved allocation between risk-free and risky assets that could lead to less leverage in the market.Originality/valueThe study is the first to use such a sentiment indicator in the traditional MV framework and show the math.

Modeling of Risk Aversion Linked to Renewable Energy Policy and Decision-Maker Behavior

This paper presents the behavior of decision makers, the possible choices and the strategies 1 resulting from the uncertainties related to the integration of renewable energies. Its uncertainties 2 are the risks associated with the volatility of renewable sources, the dynamics of energy production 3 as well as the planning and operation of the electricity grid. The goal is to model the risk-averse 4 decision-maker’s behavior and the choice of integrating renewable energies into the electrical system. 5 Following a bibliographic approach, we expose a methodology to model the decision-maker’s 6 behavior(risk aversion and predilection for risk) to risk taking. The risk-averse decision maker may 7 adopt nonlinear utility functions. Risk aversion is a behavior that reflects the desire to avoid risk 8 decisions and thus reduces the risk of adverse consequences. A decision support tool is provided to 9 the decision-maker to choose a best-fit strategy based on his preferences. The rational and risk-averse 10 decision-maker would seek to maximize a concave utility function instead of seeking to minimize its 11 cost. Taste or aversion to risk can be modeled by a thematic function of utility.

Impact of Induced Moods, Sensation Seeking, and Emotional Contagion on Economic Decisions Under Risk

In addition to probabilities of monetary gains and losses, personality traits, socio-economic factors, and specific contexts such as emotions and framing influence financial risk taking. Here, we investigated the effects of joyful, neutral, and sad mood states on participants’ risk-taking behaviour in a simple task with safe and risky options. We also analysed the effect of framing on risk taking. In different trials, a safe option was framed in terms of either financial gains or losses. Moreover, we investigated the effects of emotional contagion and sensation-seeking personality traits on risk taking in this task. We did not observe a significant effect of induced moods on risk taking. Sad mood resulted in a slight non-significant trend of risk aversion compared to a neutral mood. Our results partially replicate previous findings regarding the presence of the framing effect. As a novel finding, we observed that participants with a low emotional contagion score demonstrated increased risk aversion during a sad mood and a similar trend at the edge of significance was present in high sensation seekers. Overall, our results highlight the importance of taking into account personality traits of experimental participants in financial risk-taking studies.

Does COVID-19 really make people risk aversion in investment decision-making?

The economic fallout from COVID-19 pandemic changes individuals’ investment perceptions and behaviors in a tremendous way. Consequently, investment decision-making has been affected as people have to adjust to the new environment. This study aims to study whether COVID-19 really make people risk aversion due to the economic slowdown. Our empirical results are analyzed from household finance data in U.S in July 2021. It is found that COVID-19 proximity, income, and occupation are positively associate with risking taking in investment decision-making, while age and family size are not. This study contributes to the newly emerged body of knowledge on post pandemic investment decision-making and risk behavior analysis and provide implications for financial investment institutions.