Is the Price Kernel Monotone?
AbstractWe provide a new method to derive the state price density per unit probability based on option prices and GARCH model. We derive the risk neutral distribution using the result in Breeden and Litzenberger (1978) and the historical density adapting the GARCH model of Barone-Adesi, Engle, and Mancini (2008). We take the ratio of these two probabilities in order to describe the shape of the state price density and to evaluate its consistency with economic theory. We find that using a large dataset and introducing non-Gaussian innovations, the pricing kernel puzzle that arises in Jackwerth (2000) disappears both in a single day and over an average of different days with options expiring at the same maturity. We also evaluate the price kernel at the onset of the recent crisis.
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Bibliographic InfoPaper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 10-03.
Length: 32 pages
Date of creation: Jan 2010
Date of revision: Apr 2010
Pricing kernel; State price density per unit probability; Risk neutral; Historical distribution;
Find related papers by JEL classification:
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
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- Beare, Brendan K., 2011. "Measure preserving derivatives and the pricing kernel puzzle," Journal of Mathematical Economics, Elsevier, vol. 47(6), pages 689-697.
- Beare, Brendan K. & Schmidt, Lawrence, 2011. "An Empirical Test of Pricing Kernel Monotonicity," University of California at San Diego, Economics Working Paper Series qt5572n8pc, Department of Economics, UC San Diego.
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