Theoretical Relation between Expected Option Returns and Pricing Kernel

Abstract

This research is aimed at examining the theoretical relations between expected option returns and a pricing kernel. Under mild assumptions, it is demonstrated that the condition of the tail of the pricing kernel slope characterizes the slope and curvature of the expected option returns. This study also determines the threshold levels of the pricing kernel for each case in which the expected call returns are negative or the expected put returns exceed the risk-free rate, thereby violating the classical asset pricing theory. The results of this study are more comprehensive and informative than those of previous works.