Working Paper

The Pricing Kernel in Options

Abstract: The empirical option valuation literature specifies the pricing kernel through the price of risk, or defines it implicitly as the ratio of risk-neutral and physical probabilities. Instead, we extend the economically appealing Rubinstein-Brennan kernels to a dynamic framework that allows pathand volatility-dependence. Because of low statistical power, kernels with different economic properties can produce similar overall option fit, even when they imply cross-sectional pricing anomalies and implausible risk premiums. Imposing parsimonious economic restrictions such as monotonicity and path-independence (recovery theory) achieves good option fit and reasonable estimates of equity and variance risk premiums, while resolving pricing kernel anomalies.

Keywords: maximum likelihood estimation; option pricing; price of risk; pricing kernel; risk premium;

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Bibliographic Information

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

Part of Series: Finance and Economics Discussion Series

Publication Date: 2023-04-07

Number: 2023-053