Volatility and the Pricing Kernel

Abstract

We use options and return data to show that negative stock market returns are significantly more painful to investors when they occur in periods of low volatility. In contrast, popular asset pricing theories imply that the pricing of stock market risk does not vary with volatility, or that it moves in the opposite direction. Our finding suggests that stock market volatility evolves largely independently from the pricing kernel. We embed this assumption into a consumption-based model with a disappointment averse investor. The model captures the dynamics of the pricing kernel and resolves four recent puzzles about stock market risk premia.

Keywords: Pricing kernel, volatility, equity index options, tail risk, recovery, habits, long-run risks, rare disasters, incomplete markets

JEL Classification: G12, G13, G33