IV.

The Pricing Kernel and Option Pricing

Xiaoquan Liu
Department of Statistics and Finance University of Science and Technology of China Spring 2011

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Outline

What is a pricing kernel? Liu, Shackleton, Taylor, and Xu (2009) Kuo, Liu, and Coakley (2010)

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Option pricing
in general we have c (K ) = e rT E Q [(ST K )+ ] = e rT
0

(x K )+ fQ (x )dx (x K )+ fQ (x ) fP (x )dx fP (x )

= e rT
0

=
0

(x K )+ m(x )fP (x )dx

= E P [m(ST )(ST K )+ ] the pricing kernel, also called the stochastic discount factor, is the random variable m(ST ) fQ (x ) m(x ) = e rT fP (x )
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A representative agent

In a general equilibrium, assume a representative agent faces the problem of maximizing expected utility over consumption, given budget constraint and market clearing conditions,

max Et [
j =0

j u (ct +j )]

where ct +j is consumption at time t + j and is a time discount factor

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Representative agents problem

If we simplify the problem to a single period from t to t + 1, the problem is max u (ct ) + Et [u (ct +1 )]

subject to ct = et pt ct +1 = et +1 + xt +1 where : e: p: x: the holding of the asset by the agent the original consumption level if nothing is traded price of the asset payo of the asset

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Solving the problem

Forming a Lagrangian L = u (ct ) + Et [u (ct +1 )] + t (et ct pt ) + t +1 (et +1 ct +1 + xt +1 ) taking the rst order conditions, L = 0 u (ct ) t = 0 ct L = 0 Et [u (ct +1 )] t +1 = 0 ct +1 L = 0 t pt + t +1 xt +1 = 0

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The pricing kernel

simplify to get pt u (ct ) = Et [ u (ct +1 )xt +1 ] u (ct +1 ) p t = Et xt +1 u (ct ) so the pricing kernel can also be written as mt +1 = in discrete we have the relationship s = s (1 + rF ) u ( c1 s ) u (c0 ) u (ct +1 ) u (ct )

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The pricing kernel

the basic pricing formula for all assets is pt = Et [mt +1 xt +1 ] or simply E [mR ] = 1 the pricing kernel must be positive it must be downward sloping

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Liu, Shackleton, Taylor, and Xu (2009)

the pricing kernel is estimated as the ratio of RND and physical distributions RND is assumed to follow (1) a mixture of 2 lognormal distributions (2) the generalized beta distribution of the 2nd kind (GB2) (3) the cubic spline physical distribution is estimated using the GJR-GARCH model the geometric mean of the ratios over time are relatively smooth; its generally downward sloping but there is a small hump in the middle

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Kuo, Liu, and Coakley (2010)

specify functional form for the pricing kernel for LIBOR futures options follows the intertemporal CAPM of Merton (1973) and makes use of state variables, which are economic variables whose innovations can forecast future returns sample period is from 2000.01 to 2008.2, monthly frequency

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Kuo, Liu, and Coakley (2010): Methodology

Test the following two functional forms with GMM A power function of returns on wealth and an exponential function of the sv m = c0 (1 + RW ) e c1 r +c2 +c3 with moment condition i ,t +1 )|It ] = 1 E [c0 (1 + RW ) e c1 r +c2 +c3 (1 + R

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Kuo, Liu, and Coakley (2010): Methodology

A sum of orthogonal Chebyshev polynomials in wealth and an exponential function of the sv (Chapman (1997) and Rosenberg and Engle (2002)) m = (RW )e c1 r +c2 +c3
n

(RW ) = 0 C0 (1 + RW ) +
k =1

k Ck (1 + RW )

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To Recap

the pricing kernel contains information essential for asset pricing E (mR ) = 1 it can be derived as the ratio between RND and physical distribution, hence intimate relation between the pricing kernel, RND, and physical distribution alternatively, we can assume specic functional forms that contains a measure for investor risk aversion using econometric method, we can estimate a pricing kernel that conforms to economic theory by being everywhere positive and monotonically downward slopingh

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Empirical Pricing Kernels for FTSE 100 Index Options from 1993.07 to 2003.12
3

0 0.9 0.95 1 X/F MLN/Historical GB2/Historical 1.05 1.1

FIGURE 1. Market-related component of the pricing kernels estimated by the GMM

The pricing kernels are either with real interest rate (1 sv), with real interest rate and maximum Sharpe ratio (2 sv), or with real interest rate, maximum Sharpe ratio, and volatility (3 sv), where sv stands for state variables.

Isoelastic form 1.35 1.3 1.25 1 sv 2 sv 3 sv 15

3term polynomial form 20 15 10 5

4term polynomial form

10

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1.2 1.15 1.1 1.05 1 0.95 0.9 0.85 0.8 0.9 0.95 1 1.05 Market return 1.1

0 0 5 5 10 1 sv 2 sv 3 sv 0.95 1 1.05 Market return 1.1 10 15 20 0.9 1 sv 2 sv 3 sv 0.95 1 1.05 Market return 1.1

15

20 0.9

FIGURE 2. Market-related component of the pricing kernels estimated by minimizing the second HJ distance
The pricing kernels are either with real interest rate (1 sv), with real interest rate and maximum Sharpe ratio (2 sv), or with real interest rate, maximum Sharpe ratio, and volatility (3 sv), where sv stands for state variables.

Isoelastic form 1.6 1.5 1 sv 2 sv 3 sv

3term polynomial form 1 sv 2 sv 3 sv

4term polynomial form 1 sv 2 sv 3 sv

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1.4 1.3 1.2 1.1 1 0.9 0.8 0.7 0.6 0.95 1 Market return 1.05

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0.95

1 Market return

1.05

0.95

1 Market return

1.05