Is the Price Kernel Monotone?

33 Pages Posted: 24 Jan 2010 Last revised: 7 May 2010

See all articles by Giovanni Barone-Adesi

Giovanni Barone-Adesi

University of Lugano; Swiss Finance Institute

Hakim Dall'O

Swiss Finance Institute at the University of Lugano

Multiple version iconThere are 2 versions of this paper

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

Barone-Adesi, Giovanni and Dall'O, Hakim, Is the Price Kernel Monotone? (April 2010). Swiss Finance Institute Research Paper No. 10-03, Available at SSRN: https://ssrn.com/abstract=1540446 or http://dx.doi.org/10.2139/ssrn.1540446

Giovanni Barone-Adesi

University of Lugano ( email )

Via Buffi 13
CH-6904 Lugano
Switzerland
+41 58 666 4671 (Phone)
+41 58 666 46 47 (Fax)

Swiss Finance Institute

c/o University of Geneva
40 Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Hakim Dall'O (Contact Author)

Swiss Finance Institute at the University of Lugano ( email )

Via Buffi 13
Lugano, CH-6900
Switzerland
+41 58 666 4497 (Phone)

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