The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory

Abstract

The pricing kernel puzzle of Jackwerth (2000) concerns the fact that the empirical pricing kernel implied in S&P 500 index options and index returns is not monotonically decreasing in wealth as standard economic theory would suggest. Thus, those options are currently priced in a way such that any risk-averse investor would increase his/her utility by trading in them. We provide a representative agent model where volatility is a function of a second momentum state variable. This model is capable of generating the empirical patterns in the pricing kernel, albeit only for parameter constellations that are not typically observed in the real world.

Citation

Brown, D.P. and Carsten Jackwerth, J. (2012), "The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory", Batten, J.A. and Wagner, N. (Ed.) Derivative Securities Pricing and Modelling (Contemporary Studies in Economic and Financial Analysis, Vol. 94), Emerald Group Publishing Limited, Leeds, pp. 155-183. https://doi.org/10.1108/S1569-3759(2012)0000094009