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The Pricing Kernel Puzzle: A Real Phenomenon or a Statistical Artifact?

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  • Hammad Siddiqi
  • Sajid Anwar

Abstract

A large literature finds evidence that the pricing kernels estimated from option prices and historical returns are not monotonically decreasing in market returns. We show that the inevitable coalescence of contingencies, especially in the left‐tail, associated with estimating a distribution function may give rise to a nonmonotonic empirical pricing kernel even if the actual pricing kernel is monotonic. Hence, the observed nonmonotonicity of pricing kernels may be a statistical artifact rather than a real phenomenon. We argue that empirical work should explicitly correct for this effect by widening the option pricing bounds associated with monotonic pricing kernels.

Suggested Citation

  • Hammad Siddiqi & Sajid Anwar, 2020. "The Pricing Kernel Puzzle: A Real Phenomenon or a Statistical Artifact?," International Review of Finance, International Review of Finance Ltd., vol. 20(2), pages 485-491, June.
    • Handle: RePEc:bla:irvfin:v:20:y:2020:i:2:p:485-491
    DOI: 10.1111/irfi.12207
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    References listed on IDEAS

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    1. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    2. Matthew Linn & Sophie Shive & Tyler Shumway, 2018. "Pricing Kernel Monotonicity and Conditional Information," The Review of Financial Studies, Society for Financial Studies, vol. 31(2), pages 493-531.
    3. Jackwerth, Jens Carsten, 2000. "Recovering Risk Aversion from Option Prices and Realized Returns," The Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 433-451.
    4. Garcia, Rene & Gencay, Ramazan, 2000. "Pricing and hedging derivative securities with neural networks and a homogeneity hint," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 93-115.
    5. Nikola Gradojevic & Ramazan Gencay & Dragan Kukolj, 2009. "Option Pricing with Modular Neural Networks," Working Paper series 32_09, Rimini Centre for Economic Analysis.
    6. Ritchken, Peter H, 1985. "On Option Pricing Bounds," Journal of Finance, American Finance Association, vol. 40(4), pages 1219-1233, September.
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