Abstract

We empirically estimate the option implied coefficient of risk aversion of the market maker for European S&P 500 index options (SPX), involving asset allocation and option market making problems in the presence of proportional transaction costs in trading the underlying asset. We assume that the market maker has constant relative risk aversion utility and holds a two-asset portfolio consisting of the underlying and the riskless asset for a fixed, finite investment horizon which exceeds the option maturity, and she enters a position in the option market with an optimized portfolio. We follow the discrete time approach of Czerwonko and Perrakis (2016a, 2016b) to derive the market maker’s simple investment policy and value functions, and apply a value matching condition to find option upper and lower bounds. Data on the S&P 500 index and the SPX options is collected over the period 1996–2016, 244 months in total, and the major variable, volatility, is re-estimated under the physical distribution. By matching observed SPX prices with numerically derived reservation prices, we estimate the level of implied risk aversion. Results show that in general, the market maker has lower risk aversion compared to investors who she trades with in order to accomplish a trade. A pattern that high risk aversion precedes rare market events is also exhibited, suggesting that a market maker may adopt a waiting policy if market events can be anticipated due to the information asymmetry.