Empirical pricing kernels |
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Institution: | 1. London School of Economics, Houghton Street, London WC2A 2AE, UK;2. University of Chicago, Booth School of Business, 5807 S Woodlawn Ave, Chicago, IL 60637, USA;1. King''s College London, London WC2B 4BG, UK;2. University of Cyprus, Nicosia, Cyprus;3. MIT Sloan School of Management, Cambridge, MA, USA;1. Washington University, St. Louis, MO 63130, USA;2. Yale University, New Haven, CT 06520, USA;1. Desautels Faculty of Management, McGill University, Bronfman Building, 1001 Sherbrooke St West, Montreal H3A 1G5, Canada;2. Bank for International Settlements, Centralbahnplatz 2, 4051 Basel, Switzerland |
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Abstract: | This paper investigates the empirical characteristics of investor risk aversion over equity return states by estimating a time-varying pricing kernel, which we call the empirical pricing kernel (EPK). We estimate the EPK on a monthly basis from 1991 to 1995, using S&P 500 index option data and a stochastic volatility model for the S&P 500 return process. We find that the EPK exhibits counter cyclical risk aversion over S&P 500 return states. We also find that hedging performance is significantly improved when we use hedge ratios based the EPK rather than a time-invariant pricing kernel. |
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