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

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