Finance and Economics Discussion Series (FEDS)
August 2023
The Pricing Kernel in Options
Steven Heston, Kris Jacobs, Hyung Joo Kim
Abstract:
The empirical option valuation literature specifies the pricing kernel through the price of risk, or defines it implicitly as the ratio of risk-neutral and physical probabilities. Instead, we extend the economically appealing Rubinstein-Brennan kernels to a dynamic framework that allows pathand volatility-dependence. Because of low statistical power, kernels with different economic properties can produce similar overall option fit, even when they imply cross-sectional pricing anomalies and implausible risk premiums. Imposing parsimonious economic restrictions such as monotonicity and path-independence (recovery theory) achieves good option fit and reasonable estimates of equity and variance risk premiums, while resolving pricing kernel anomalies.
Keywords: maximum likelihood estimation, option pricing, price of risk, pricing kernel, risk premium
DOI: https://doi.org/10.17016/FEDS.2023.053
PDF: Full Paper
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