August 2023

The Pricing Kernel in Options

Steven Heston, Kris Jacobs, Hyung Joo Kim


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


PDF: Full Paper

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Last Update: August 09, 2023