Working Paper

A Tale of Two Option Markets: Pricing Kernels and Volatility Risk

Abstract: Using prices of both S&P 500 options and recently introduced VIX options, we study asset pricing implications of volatility risk. While pointing out the joint pricing kernel is not identified nonparametrically, we propose model-free estimates of marginal pricing kernels of the market return and volatility conditional on the VIX. We find that the pricing kernel of market return exhibits a decreasing pattern given either a high or low VIX level, whereas the unconditional estimates present a U-shape. Hence, stochastic volatility is the key state variable responsible for the U-shape puzzle documented in the literature. Finally, our estimates of the volatility pricing kernel feature a U-shape, implying that investors have high marginal utility in both high and low volatility states.

Keywords: Pricing kernel; volatility risk; VIX option; state-price density;

JEL Classification: G12; G13;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2014-01-30

Number: 2014-58

Pages: 44 pages