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An Empirical Test of Pricing Kernel Monotonicity

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  • Beare, Brendan K.
  • Schmidt, Lawrence

Abstract

A recent literature in finance concerns a curious recurring feature of estimated pricing kernels. Classical theory dictates that the pricing kernel { defined loosely as the ratio of Arrow security prices to an objective probability measure { should be a decreasing function of aggregate resources. Yet a large number of recent empirical studies appear to contradict this prediction. The nonmonotonicity of empirical pricing kernel estimates has become known as the pricing kernel puzzle. In this paper we propose and apply a formal statistical test of pricing kernel monotonicity. The test involves assessing the concavity of the ordinal dominance curve associated with the risk neutral and physical return distributions. We apply the test using thirteen years of data from the market for European put and call options written on the S&P 500 index. Statistically significant violations of pricing kernel monotonicity occur in a substantial proportion of months.

Suggested Citation

  • 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.
  • Handle: RePEc:cdl:ucsdec:qt5572n8pc
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    Cited by:

    1. Beare, Brendan K., 2011. "Measure preserving derivatives and the pricing kernel puzzle," Journal of Mathematical Economics, Elsevier, vol. 47(6), pages 689-697.
    2. Denis Belomestny & Shujie Ma & Wolfgang Karl Härdle, 2015. "Pricing Kernel Modeling," SFB 649 Discussion Papers SFB649DP2015-001, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    3. 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.
    4. Victor Chernozhukov & Whitney K. Newey & Andres Santos, 2015. "Constrained conditional moment restriction models," CeMMAP working papers CWP59/15, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
    5. 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.
    6. beare, brendan & shi, xiaoxia, 2015. "An improved bootstrap test of density ratio ordering," MPRA Paper 74772, University Library of Munich, Germany.
    7. repec:eee:empfin:v:44:y:2017:i:c:p:19-35 is not listed on IDEAS

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    Keywords

    finance; empirical pricing kernels; Social and Behavioral Sciences;

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