Option-Implied Price of Risk

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