The Pricing Kernel Puzzle: A Real Phenomenon or a Statistical Artifact?

Hammad Siddiqi and Sajid Anwar

International Review of Finance, 2020, vol. 20, issue 2, 485-491

Abstract: A large literature finds evidence that the pricing kernels estimated from option prices and historical returns are not monotonically decreasing in market returns. We show that the inevitable coalescence of contingencies, especially in the left‐tail, associated with estimating a distribution function may give rise to a nonmonotonic empirical pricing kernel even if the actual pricing kernel is monotonic. Hence, the observed nonmonotonicity of pricing kernels may be a statistical artifact rather than a real phenomenon. We argue that empirical work should explicitly correct for this effect by widening the option pricing bounds associated with monotonic pricing kernels.

Date: 2020
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