Three Solutions to the Pricing Kernel Puzzle
Review of Finance, Vol. 17, Issue 3, pp. 1065-1098, 2013
34 Pages Posted: 13 Apr 2010 Last revised: 20 Oct 2013
Date Written: January 27, 2012
The pricing kernel is an important link between economics and finance. In standard models of financial economics it is proportional to the aggregate marginal utility in the economy. We first how that none of the three standard assumptions (completeness, risk aversion, and correct beliefs) is needed for the pricing kernel to be generally decreasing. If at least one of the three assumptions is violated, the pricing kernel can have increasing parts. We explain the economic principles that lead to an increasing part in the pricing kernel and compare the resulting pricing kernels with the empirical pricing kernel estimated in Jackwerth (2000).
Keywords: Pricing kernel puzzle, Financial market equilibrium, Risk-seeking behaviour, Biased beliefs, Incomplete markets
JEL Classification: D53, G12
Suggested Citation: Suggested Citation