Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/184801 
Year of Publication: 
2018
Series/Report no.: 
Working Paper No. 850
Publisher: 
Queen Mary University of London, School of Economics and Finance, London
Abstract: 
We propose a new predictor of U.S. real economic activity (REA), namely the representative investor's implied relative risk aversion (IRRA) extracted from S&P 500 option prices. IRRA is forward-looking and hence, it is expected to be related to future economic conditions. We document that U.S. IRRA predicts U.S. REA both in-and out-of-sample once we control for well-known REA predictors and take into account their persistence. An increase (decrease) in IRRA predicts a decrease (increase) in REA. We extend the empirical analysis by extracting IRRA from the South Korea, UK, Japanese and German index option markets. We find that South Korea IRRA predicts the South Korea REA both in-and out-of-sample, as expected given the high liquidity of its index option market. We show that a parsimonious yet flexible production economy model calibrated to the U.S. economy can explain the documented negative relation between risk aversion and future economic growth.
Subjects: 
Option prices
Risk aversion
Risk-neutral moments
Real Economic Activity
Production economy model
JEL: 
E44
G13
G17
Document Type: 
Working Paper

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