Option market trading activity and the estimation of the pricing kernel A Bayesian approach

42 Pages Posted: 23 Jan 2016 Last revised: 7 Aug 2020

See all articles by Giovanni Barone-Adesi

Giovanni Barone-Adesi

University of Lugano; Swiss Finance Institute

Nicola Fusari

Johns Hopkins University - Carey Business School

Carlo Sala

ESADE Business School

Antonietta Mira

Università della Svizzera italiana - InterDisciplinary Institute of Data Science

Date Written: October 24, 2017

Abstract

We propose a nonparametric Bayesian approach for the estimation of the pricing kernel. Historical stock returns and option market data are combined through the Dirichlet Process (DP) to construct an option-adjusted physical measure. The precision parameter of the DP process is calibrated to the amount of trading activity in deep-out-of-the-money options. We use the option-adjusted physical measure to construct an option-adjusted pricing kernel. An empirical investigation on the S&P 500 Index from 2002 to 2015 shows that the option-adjusted pricing kernel is consistently monotonically decreasing, regardless of the level of volatility, thus providing an explanation to the well known U-shaped pricing kernel puzzle.

Keywords: Pricing kernelPricing kernel puzzlePhysical measureDirichlet processBayesian nonparametric estimationOptionsS&P 500 index

JEL Classification: G10, G13, G14, G17

Suggested Citation

Barone-Adesi, Giovanni and Fusari, Nicola and Sala, Carlo and Mira, Antonietta, Option market trading activity and the estimation of the pricing kernel A Bayesian approach (October 24, 2017). Journal of Econometrics, Vol. 216, No. 2, 2020, Available at SSRN: https://ssrn.com/abstract=2720180 or http://dx.doi.org/10.2139/ssrn.2720180

Giovanni Barone-Adesi

University of Lugano ( email )

Via Buffi 13
CH-6904 Lugano
Switzerland
+41 58 666 4671 (Phone)
+41 58 666 46 47 (Fax)

Swiss Finance Institute

c/o University of Geneva
40 Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Nicola Fusari

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

Carlo Sala (Contact Author)

ESADE Business School ( email )

Avenida de Torreblanca 59
Barcelona, Barcelona 08172
Spain

HOME PAGE: http://www.people.usi.ch/salaca

Antonietta Mira

Università della Svizzera italiana - InterDisciplinary Institute of Data Science ( email )

Via Giuseppe Buffi 13
CH-6900 Lugano, CH-6904
Switzerland

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