The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory

24 Pages Posted: 27 Feb 2002

See all articles by Jens Carsten Jackwerth

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

David P. Brown

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Date Written: November 9, 2001

Abstract

One of the central questions in financial economics is the determination of asset prices, such as the value of a stock. Over the past three decades, research on this topic has converged on a concept called the "state-price density". However, a puzzle has arisen. On the one hand, Cox, Ingersoll, and Ross (1985) and others argue that the ratio of the state-price density to the statistical probability density, which is commonly known as the pricing kernel, should decrease monotonically as the aggregate wealth of an economy rises. On the other hand, recent empirical work on options on the S&P 500 index suggests that, for a sizable range of index levels, the pricing kernel is increasing instead of decreasing. We investigate theoretical explanations to this puzzle. Our existing work has ruled out some alternative hypotheses, such as data imperfections and methodological problems. We provide a representative agent model where volatility is a function of a second momentum state variable. This model is capable of generating the empirical patterns in the pricing kernel. We estimate the model through GMM.

Keywords: Derivatives, Asset Pricing, Option Pricing, Empirical Studies

Suggested Citation

Jackwerth, Jens Carsten and Brown, David P., The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory (November 9, 2001). Available at SSRN: https://ssrn.com/abstract=301820 or http://dx.doi.org/10.2139/ssrn.301820

Jens Carsten Jackwerth (Contact Author)

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

David P. Brown

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-265-5281 (Phone)
608-265-4195 (Fax)

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