Estimating risk aversion, Risk-Neutral and Real-World Densities using Brazilian Real currency options

• Main Authors: José Fajardo, José Renato Haas Ornelas, Aquiles Rocha de Farias
• Format: Article
• Language: Portuguese
• Published: Universidade de São Paulo 2012-12-01
• Series: Economia Aplicada
• Subjects: Aversão Relativa ao Risco; Densidade Neutra ao Risco; Taxa de Câmbio
• Online Access: http://www.scielo.br/scielo.php?script=sci_arttext&pid=S1413-80502012000400002&lng=en&tlng=en

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.