The Pricing Kernel in Options

Steven Heston (), Kris Jacobs () and Hyung Joo Kim
Additional contact information
Steven Heston: https://www.rhsmith.umd.edu/directory/steve-heston
Kris Jacobs: https://www.bauer.uh.edu/search/directory/profile.asp?firstname=Kris&lastname=Jacobs
Hyung Joo Kim: https://www.federalreserve.gov/econres/hyung-joo-kim.htm

No 2023-053, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

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 (search for similar items in EconPapers)
Pages: 64 pages
Date: 2023-04-07
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:96652

DOI: 10.17016/FEDS.2023.053

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