Can market volumes reveal traders' rationality and a new risk premium?

TL;DR

This paper investigates how market trading volumes can indicate traders' beliefs and risk preferences, introducing a model that estimates average risk aversion and reveals a new risk premium linked to market volume.

Contribution

It presents a novel trading strategy model within the optimal Merton framework that captures collective trader behavior and links volume to risk premium estimation.

Findings

Market volumes relate to traders' belief and risk aversion.

The model estimates average risk aversion from market data.

Empirical data supports the model's validity.

Abstract

An empirical analysis, suggested by optimal Merton dynamics, reveals some unexpected features of asset volumes. These features are connected to traders' belief and risk aversion. This paper proposes a trading strategy model in the optimal Merton framework that is representative of the collective behavior of heterogeneous rational traders. This model allows for the estimation of the average risk aversion of traders acting on a specific risky asset, while revealing the existence of a price of risk closely related to market price of risk and volume rate. The empirical analysis, conducted on real data, confirms the validity of the proposed model.