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The Pricing Kernel in Options
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 ...