Chapter2012

The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory

75 citations0/0 files storedContemporary studies in economic and financial analysis

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Stochastic processes and financial applications Financial Markets and Investment Strategies Financial Risk and Volatility Modeling

Abstract

The pricing kernel puzzle of Jackwerth (2000) concerns the fact that the empirical pricing kernel implied in S&P 500 index options and index returns is not monotonically decreasing in wealth as standard economic theory would suggest. Thus, those options are currently priced in a way such that any risk-averse investor would increase his/her utility by trading in them. We provide a representative agent model where volatility is a function of a second momentum state variable. This model is capable of generating the empirical patterns in the pricing kernel, albeit only for parameter constellations that are not typically observed in the real world.

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References

1993A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options 1969Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case 1978Asset Prices in an Exchange Economy 1989Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework 1987Expected stock returns and volatility 1989Why Does Stock Market Volatility Change Over Time?1991Inferring Trade Direction from Intraday Data 1988Permanent and Temporary Components of Stock Prices

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2014An Empirical Test of Pricing Kernel Monotonicity 2016The Pricing Kernel Puzzle: Survey and Outlook 2015Learning, confidence, and option prices 2012Three Solutions to the Pricing Kernel Puzzle 2017Option Valuation with Volatility Components, Fat Tails, and Nonmonotonic Pricing Kernels*2009Monotonicity of the Stochastic Discount Factor and Expected Option Returns

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