Equilibrium Market Prices of Risks and Market Risk Aversion in a Complete Stochastic Volatility Model with Habit Formation
Posted: 4 May 2010 Last revised: 18 Oct 2010
Date Written: April 26, 2010
Considering a pure exchange economy with habit formation utility, this paper explores the equilibrium relationships between the market pricing kernel, the market prices of risks and the market risk aversion under a continuous time stochastic volatility model completed by liquidly traded put options. We demonstrate with these equilibrium relations that the risk neutral pricing partial differential equation is a restricted version of the fundamental pricing equation provided in Garman (1976). We also show that in this completed market stochastic volatility cannot explain the documented empirical pricing kernel puzzle (Jackwerth (2000)). Instead, a habit formation utility offers a possible explanation of the puzzle. The derived quantitative relation between the market prices of risks and the market risk aversion also provides a new way to extract empirical market risk aversion.
Keywords: Market Price of Risk, Pricing Kernel, Risk Aversion, Habit Formation, Stochastic Volatility Model
JEL Classification: G12
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