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Returns of claims on the upside and the viability of U-shaped pricing kernels

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  • Bakshi, Gurdip
  • Madan, Dilip
  • Panayotov, George
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    Abstract

    When the pricing kernel is U-shaped, then expected returns of claims with payout on the upside are negative for strikes beyond a threshold, determined by the slope of the U-shaped kernel in its increasing region, and have negative partial derivative with respect to strike in the increasing region of the kernel. Using returns of (i) S&P 500 index calls, (ii) calls on major international equity indexes, (iii) digital calls, (iv) upside variance contracts, and (v) a theoretical construct that we denote as kernel call, we find broad support for the implications of U-shaped pricing kernels. A possible theoretical reconciliation of our empirical findings is explored through a model that accommodates heterogeneity in beliefs about return outcomes and short-selling.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 97 (2010)
    Issue (Month): 1 (July)
    Pages: 130-154

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    Handle: RePEc:eee:jfinec:v:97:y:2010:i:1:p:130-154

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    Web page: http://www.elsevier.com/locate/inca/505576

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    Keywords: U-shaped pricing kernels Claims on the upside Monotonically declining pricing kernels Expected returns Negative average option returns Short-selling Heterogeneity in beliefs;

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    3. Chang, Eric C. & Luo, Xingguo & Shi, Lei & Zhang, Jin E., 2013. "Is warrant really a derivative? Evidence from the Chinese warrant market," Journal of Financial Markets, Elsevier, vol. 16(1), pages 165-193.
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    5. Anthonisz, Sean A., 2012. "Asset pricing with partial-moments," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 2122-2135.
    6. Beare, Brendan K., 2011. "Measure preserving derivatives and the pricing kernel puzzle," Journal of Mathematical Economics, Elsevier, vol. 47(6), pages 689-697.
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    8. Matthias Fengler & Helmut Herwartz & Christian Werner, 2010. "A dynamic copula approach to recovering the index implied volatility skew," University of St. Gallen Department of Economics working paper series 2010 1132, Department of Economics, University of St. Gallen, revised Nov 2011.
    9. Audrino, Francesco & Meier, Pirmin, 2012. "Empirical pricing kernel estimation using a functional gradient descent algorithm based on splines," Economics Working Paper Series 1210, University of St. Gallen, School of Economics and Political Science.
    10. Polkovnichenko, Valery & Zhao, Feng, 2013. "Probability weighting functions implied in options prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 580-609.
    11. Maria Grith & Wolfgang Karl Härdle & Volker Krätschmer, 2013. "Reference Dependent Preferences and the EPK Puzzle," SFB 649 Discussion Papers SFB649DP2013-023, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    12. Audrino, Francesco & Huitema, Robert & Ludwig, Markus, 2014. "An Empirical Analysis of the Ross Recovery Theorem," Economics Working Paper Series 1411, University of St. Gallen, School of Economics and Political Science.
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