Estimating risk aversion, risk-neutral and real-world densities using brazilian 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.