Option-Implied Price of Risk

57 Pages Posted: 20 Dec 2019

Date Written: December 4, 2019

Abstract

I use index prices and options to estimate the pricing kernel's elasticity, which equals the market price of risk. I show that my estimate predicts future market returns, is priced in a cross-sectional analysis, and that it is highly correlated to business cycle variables. Building on the external habits model of Campbell and Cochrane (1999), I rationalize my results by assuming a time-varying relationship between consumption growth and market returns, and therefore introduce a new way of estimating the latent surplus consumption ratio without using problematic consumption data. My results provide novel empirical support for consumption-based asset pricing models.

Keywords: Pricing kernel elasticity, market price of risk, surplus consumption ratio, risk aversion, elasticity of intertemporal substitution, return predictability

JEL Classification: E44, G1

Suggested Citation

Kontoghiorghes, Alexander P., Option-Implied Price of Risk (December 4, 2019). Available at SSRN: https://ssrn.com/abstract=3498529 or http://dx.doi.org/10.2139/ssrn.3498529

Alexander P. Kontoghiorghes (Contact Author)

Queen Mary University of London ( email )

Mile End Rd
London, E1 4NS
United Kingdom

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