Eatimating risk aversion, Risk-Neutral and Real-World Densities using Brasilian Real currency options

Abstract

This paper uses the Liu et al. (2007) approach to estimate the optionimplied Risk-Neutral Densities (RND), real-world density (RWD), and relative risk aversion from the Brazilian Real/US Dollar exchange rate distribution. Our empirical application uses a sample of exchange-traded Brazilian Real currency options from 1999 to 2011. Our estimated value of the relative risk aversion is around 2.7, which is in line with other articles for the Brazilian Economy. Our out-of-sample results showed that the RND has some ability to forecast the Brazilian Real exchange rate, but when we incorporate the risk aversion, the out-of-sample performance improves substantially.

Financing Costs and Development

“…The two assigned values are the inverse intertemporal elasticity of substitution parameter, σ = 1.5, and the depreciation rate, δ = 0.03. The intertemporal elasticity is in line with most of the literature on consumption surveyed by Attanasio and Weber (2010) and also with the Brazil-specific literature that estimates σ in the range from 1 to 3 (e.g., Gandelman and Hernández-Murillo, 2014;Fajardo, Ornelas, and Farias, 2012). The depreciation rate is in the common range of values used in the macro literature.…”

Dispersion in Financing Costs and Development

“…The two assigned values are the inverse intertemporal elasticity of substitution parameter, σ = 1.5, and the depreciation rate, δ = 0.06. The intertemporal elasticity is in line with most of the literature on consumption surveyed by Attanasio and Weber (2010) and also with the Brazil-specific literature that estimates σ in the range from 1 to 3 (e.g., Gandelman and Hernández-Murillo, 2014;Fajardo, Ornelas, and Farias, 2012). The depreciation rate is commonly used in the macro growth literature.…”

The Effects of Public Sector Employment on Household Savings and Labor Supply

“…11 We fix the coefficient of relative risk aversion, γ, to 2.0, in line with the bulk of the literature on consumption surveyed by Attanasio (1999). This value is also consistent with the literature that estimates γ using Brazilian data, which suggests a range from 1 to 3 (see, for example, Gandelman and Hernández-Murillo (2014) and Fajardo et al (2012)). Then we choose the share of leisure in the utility function, ρ t to match average hours for different age groups and the average labor force participitation.…”