Implied risk aversion and pricing kernel in the FTSE 100 index

Wen Ju Liao and Hao-Chang Sung

The North American Journal of Economics and Finance, 2020, vol. 54, issue C

Abstract: This paper studies the estimation of the pricing kernel and explains the pricing kernel puzzle found in the FTSE 100 index. We use prices of options and futures on the FTSE 100 index to derive the risk neutral density (RND). The option-implied RND is inverted by using two nonparametric methods: the implied-volatility surface interpolation method and the positive convolution approximation (PCA) method. The actual density distribution is estimated from the historical data of the FTSE 100 index by using the threshold GARCH (TGARCH) model. The results show that the RNDs derived from the two methods above are relatively negatively skewed and fat-tailed, compared to the actual probability density, that is consistent with the phenomenon of “volatility smile.” The derived risk aversion is found to be locally increasing at the center, but decreasing at both tails asymmetrically. This is the so-called pricing kernel puzzle. The simulation results based on a representative agent model with two state variables show that the pricing kernel is locally increasing with the wealth at the level of 1 and is consistent with the empirical pricing kernel in shape and magnitude.

Keywords: Pricing kernel; Risk aversion; Risk neutral density; Positive convolution approximation; Volatility smile; Pricing kernel puzzle (search for similar items in EconPapers)
JEL-codes: C14 G12 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:54:y:2020:i:c:s1062940818302092

DOI: 10.1016/j.najef.2018.08.009

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