Pricing kernel modeling

Abstract

We propose a new method to estimate the empirical pricing kernel based on option data. We estimate the pricing kernel nonparametrically by using the ratio of the risk-neutral density estimator and the subjective density estimator. The risk-neutral density is approximated by a weighted kernel density estimator with varying unknown weights for different observations, and the subjective density is approximated by a kernel density estimator with equal weights. We represent the European call option price function by the second order integration of the risk-neutral density, so that the unknown weights are obtained through one-step penalized least squares estimation with the Kullback-Leibler divergence as the penalty function. Asymptotic results of the resulting estimators are established. The performance of the proposed method is illustrated empirically by simulation and real data application studies.