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Testing Monotonicity of Pricing Kernels

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Author Info
Yuri Golubev
Wolfgang Härdle
Roman Timonfeev

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Abstract

The behaviour of market agents has always been extensively covered in the literature. Risk averse behaviour, described by von Neumann and Morgenstern (1944) via a concave utility function, is considered to be a cornerstone of classical economics. Agents prefer a fixed profit over uncertain choice with the same expected value, however lately there has been a lot of discussion about the reliability of this approach. Some authors have shown that there is a reference point where market utility functions are convex. In this paper we have constructed a test to verify uncertainty about the concavity of agents’ utility function by testing the monotonicity of empirical pricing kernels (EPKs). A monotone decreasing EPK corresponds to a concave utility function while non-monotone decreasing EPK means non-averse pattern on one or more intervals of the utility function. We investigated the EPK for German DAX data for years 2000, 2002 and 2004 and found the evidence of non-concave utility functions: H0 hypothesis of monotone decreasing pricing kernel was rejected at 5% and 10% significance level in 2002 and at 10% significance level in 2000.

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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2008-001.

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Length: 28 pages
Date of creation: Jan 2008
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Handle: RePEc:hum:wpaper:sfb649dp2008-001

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Related research
Keywords: Risk Aversion; Pricing kernel;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Hypothesis Testing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Ait-Sahalia, Yacine & Wang, Yubo & Yared, Francis, 2001. "Do option markets correctly price the probabilities of movement of the underlying asset?," Journal of Econometrics, Elsevier, vol. 102(1), pages 67-110, May. [Downloadable!] (restricted)
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  3. Kai Detlefsen & Wolfgang Härdle & Rouslan Moro, 2007. "Empirical Pricing Kernels and Investor Preferences," SFB 649 Discussion Papers SFB649DP2007-017, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  4. 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. [Downloadable!] (restricted)
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  5. Rosenberg, Joshua V. & Engle, Robert F., 2002. "Empirical pricing kernels," Journal of Financial Economics, Elsevier, vol. 64(3), pages 341-372, June. [Downloadable!] (restricted)
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  6. Enzo Giacomini & Wolfgang Härdle, 2007. "Statistics of Risk Aversion," SFB 649 Discussion Papers SFB649DP2007-025, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  7. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March. [Downloadable!] (restricted)
  8. Jens Carsten Jackwerth., 1996. "Recovering Risk Aversion from Option Prices and Realized Returns," Research Program in Finance Working Papers RPF-265, University of California at Berkeley. [Downloadable!]
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  9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  10. Enzo Giacomini & Michael Handel & Wolfgang K. Härdle, 2006. "Time Dependent Relative Risk Aversion," SFB 649 Discussion Papers SFB649DP2006-020, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
  11. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-84, March. [Downloadable!] (restricted)
  12. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(2), pages 327-43. [Downloadable!] (restricted)
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  1. Wolfgang Härdle & Volker Krätschmer & Rouslan Moro, 2009. "A Microeconomic Explanation of the EPK Paradox," SFB 649 Discussion Papers SFB649DP2009-010, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany. [Downloadable!]
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