Differential Awareness of Rare Disasters and the Pricing Kernel Puzzle

33 Pages Posted: 11 May 2016 Last revised: 3 Mar 2017

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

John Quiggin

University of Queensland - Business School

Date Written: March 1, 2017

Abstract

Risk-averse expected utility maximization implies that the pricing kernel must be a non-increasing function of aggregate wealth. However, empirical research has found that the pricing kernel frequently displays a locally increasing portion in aggregate wealth. This is known as the pricing kernel puzzle. In this article, we show that if individual investors and sophisticated institutional managers perceive tail-risks differently, then there exists a range of feasible option prices that produce a locally increasing pricing kernel similar to the empirically observed pricing kernel. We show, by example, that even tiny differences in state spaces as perceived by the two investor types are sufficient to generate a non-monotonic pricing kernel.

Keywords: Differential Awareness, Pricing Kernel Puzzle, Risk Aversion, Stochastic Discount Factor

JEL Classification: D00, D40, G12, G13

Suggested Citation

Siddiqi, Hammad and Quiggin, John, Differential Awareness of Rare Disasters and the Pricing Kernel Puzzle (March 1, 2017). Available at SSRN: https://ssrn.com/abstract=2778535 or http://dx.doi.org/10.2139/ssrn.2778535

Hammad Siddiqi (Contact Author)

University of the Sunshine Coast-School of Business ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

HOME PAGE: http://www.usc.edu.au/staff-repository/dr-hammad-siddiqi

John Quiggin

University of Queensland - Business School ( email )

Brisbane, Queensland 4072
Australia

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