Differential Awareness of Rare Disasters and the Pricing Kernel Puzzle
33 Pages Posted: 11 May 2016 Last revised: 3 Mar 2017
Date Written: March 1, 2017
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: Suggested Citation