Returns of claims on the upside and the viability of U-shaped pricing kernels |
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Authors: | Gurdip Bakshi Dilip Madan George Panayotov |
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Affiliation: | 1. Smith School of Business, University of Maryland, College Park, MD 20742, USA;2. McDonough School of Business, Georgetown University, Washington, DC 20057, USA |
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Abstract: | When the pricing kernel is U-shaped, then expected returns of claims with payout on the upside are negative for strikes beyond a threshold, determined by the slope of the U-shaped kernel in its increasing region, and have negative partial derivative with respect to strike in the increasing region of the kernel. Using returns of (i) S&P 500 index calls, (ii) calls on major international equity indexes, (iii) digital calls, (iv) upside variance contracts, and (v) a theoretical construct that we denote as kernel call, we find broad support for the implications of U-shaped pricing kernels. A possible theoretical reconciliation of our empirical findings is explored through a model that accommodates heterogeneity in beliefs about return outcomes and short-selling. |
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Keywords: | U-shaped pricing kernels Claims on the upside Monotonically declining pricing kernels Expected returns Negative average option returns Short-selling Heterogeneity in beliefs |
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