Derivatives -- the View from the Trenches

Theorem 2 and Risk Aversion
Clearly the parameters
0.18, m 0.30
seem extreme. Does the market really expect market crashes
of -30% every fifth year
It is important to note, however, that these parameters are not
the historical parameters -- the are market Q measure
parameters and therefore include a healthy dose of risk
premium.
Suppose
- Historical jump intensity of 0.02.
- Historical mean jump of m 0.25.
Then in equilibrium the market jump parameters are a
function of the relative risk aversion (RRA) of the
representative agent:
RRA m
1 3% -27% 15%
2 4% -28% 15%
5 8% -33% 15%
7 15% -36% 15%
10 36% -40% 15%
So we are in RRA = 5-7 territory which by no means is
extreme.
18