A dynamic equilibrium model for U-shaped pricing kernels

Akira Yamazaki

Quantitative Finance, 2018, vol. 18, issue 5, 851-875

Abstract: This paper proposes a dynamic equilibrium model that can provide a unified explanation for the stylized facts observed in stock index markets such as the fat tails of the risk-neutral return distribution relative to the physical distribution, negative expected returns on deep OTM call options and negative realized variance risk premiums. In particular, we focus on the U-shaped pricing kernel against the stock index return, which is closely related to the negative call returns. We assume that the stock index return follows a time-changed Lévy process and that a representative investor has power utility over the aggregate consumption that forms a linear regression of the stock index return and its stochastic activity rate. This model offers a macroeconomic interpretation of the stylized facts from the perspective of the sensitivity of the activity rate and stock index return on aggregate consumption as well as the investor’s risk aversion.

Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:taf:quantf:v:18:y:2018:i:5:p:851-875

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DOI: 10.1080/14697688.2017.1388535

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