Pricing Kernels with Coskewness and Volatility Risk

Abstract

I investigate a pricing kernel in which coskewness and the market volatility risk factors are endogenously determined. I show that the price of coskewness and market volatility risk are restricted by investor risk aversion and skewness preference. The risk aversion is estimated to be between two and five and significant. The price of volatility risk ranges from -1.5% to -0.15% per year. Consistent with theory, I find that the pricing kernel is decreasing in the aggregate wealth and increasing in the market volatility. When I project my estimated pricing kernel on a polynomial function of the market return, doing so produces the puzzling behaviors observed in pricing kernel. Using pricing kernels, I examine the sources of the idiosyncratic volatility premium. I find that nonzero risk aversion and firms' non-systematic coskewness determine the premium on idiosyncratic volatility risk. When I control for the non-systematic coskewness factor, I find no significant relation between idiosyncratic volatility and stock expected returns. My results are robust across different sample periods, different measures of market volatility and firm characteristics.