Distorting Arrow-Debreu Securities: New Entropy Restrictions Implied by the Option Cross Section

66 Pages Posted: 7 Feb 2020 Last revised: 7 May 2020

See all articles by Fousseni Chabi-Yo

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

Yan Liu

Purdue University

Date Written: January 14, 2020

Abstract

Replacing equity return (as in the equity risk premium) with returns on an arbitrary contingent claim, we obtain a new class of economic risk premiums to impose upon candidate models. These risk premiums reflect the distance between the physical and risk-neutral moments for asset returns, can be estimated in a model-free fashion from the option cross section, and provide sharp information in distinguishing alternative models. Confronting leading macro-finance models with our risk premiums, we uncover a wide dispersion in performance across candidate models. Our evidence points to the importance of incorporating persistent stochastic volatilities and/or higher moments in fundamentals to reconcile with the option data, as exemplified by Bansal and Yaron (2004) and Bekaert and Engstrom (2017).

Keywords: Equity risk premium, Risk-neutral moments, Preferences, Entropy, Model-free, Stochastic Discount Factor

JEL Classification: E44, G1, G12, G13

Suggested Citation

Chabi-Yo, Fousseni and Liu, Yan, Distorting Arrow-Debreu Securities: New Entropy Restrictions Implied by the Option Cross Section (January 14, 2020). Available at SSRN: https://ssrn.com/abstract=3519667 or http://dx.doi.org/10.2139/ssrn.3519667

Fousseni Chabi-Yo (Contact Author)

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

Yan Liu

Purdue University ( email )

West Lafayette, IN 47907-1310
United States

HOME PAGE: http://yliu1.com

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