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;
https://doi.org/10.17016/FEDS.2023.053
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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