Risk Aversion, Fanning Preference, and Volatility Smirk on S&P500 Index Options

This paper proposes a novel way of pricing S&P500 index options in the presence of jump risk. Our analysis is built upon an equilibrium option pricing rule for a representative agent economy. In particular, we use the weighted utility's certainty equivalent to specify agent's risk preference, which displays a fanning out characteristic. We find that the fanning effect captures a remarkably large portion of the total market risk premium implicit in options. As a result, the model with fanning effect generates pronounced volatility smirks