Time-varying risk aversion and return predictability

The risk aversion implied in option prices contains information about the attitude of investors toward risk and therefore its variation can capture the changes in risk premiums implicit in financial markets. In this paper, we propose a new method for estimating the variations of risk aversion and examine its predictability on future excess returns. Results for the S & P 500 index show that risk aversion has predictive power for future excess returns, even for short horizons that is, two- and four-week horizons and does not lose significance in the presence of conventional forecasting variables, including dividend yield, short rate, and variance risk premium. For robustness, we conduct an additional test on Sharpe ratio prediction and these results also support the predictability of time-varying risk aversion on future Shape ratio movements.