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Measure preserving derivatives and the pricing kernel puzzle

  • Beare, Brendan K.
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    Recent empirical studies have found evidence of nonmonotonicity in the pricing kernels for a variety of market indices. This phenomenon is known as the pricing kernel puzzle. The payoff distribution pricing model of Dybvig predicts that the payoff distribution of a direct investment of $1 in a market index may be replicated by investing less than $1 in some derivative written on that market index whenever the associated pricing kernel is nondecreasing. Using the Hardy–Littlewood rearrangement inequality, we obtain an explicit solution for the cheapest replicating derivative, which we refer to as the optimal measure preserving derivative. The optimal measure preserving derivative is the permutation appearing in Ryff’s decomposition of the pricing kernel with respect to the market payoff measure. We compute optimal measure preserving derivatives corresponding to the estimated physical and risk neutral distributions in the paper by Jackwerth (2000) that first brought attention to the pricing kernel puzzle.

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

    Volume (Year): 47 (2011)
    Issue (Month): 6 ()
    Pages: 689-697

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    Handle: RePEc:eee:mateco:v:47:y:2011:i:6:p:689-697
    DOI: 10.1016/j.jmateco.2011.09.005
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