Is the Price Kernel Monotone?
33 Pages Posted: 24 Jan 2010 Last revised: 7 May 2010
There are 2 versions of this paper
Is the Price Kernel Monotone?
Date Written: April 2010
Abstract
We provide a new method to derive the state price density per unit probability based on option prices and GARCH model. We derive the risk neutral distribution using the result in Breeden and Litzenberger (1978) and the historical density adapting the GARCH model of Barone-Adesi, Engle, and Mancini (2008). We take the ratio of these two probabilities in order to describe the shape of the state price density and to evaluate its consistency with economic theory. We find that using a large dataset and introducing non-Gaussian innovations, the pricing kernel puzzle that arises in Jackwerth (2000) disappears both in a single day and over an average of different days with options expiring at the same maturity. We also evaluate the price kernel at the onset of the recent crisis.
Keywords: Pricing kernel, State price density per unit probability, Risk neutral, Historical distribution.
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation
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