Abstract
We show that if sophisticated institutional managers and individual investors perceive tail-risks differently, then a new explanation for the pricing kernel puzzle emerges. We show, by example, that even a tiny difference in tail-risk perception by the two investor types can explain the pricing kernel puzzle.
Highlights
In the presence of such differential awareness of tail-risks, there is a range of feasible index option prices that give rise to non-monotonic pricing kernels
We show that differential awareness of rare disasters between institutional investors and individual traders may cause the option prices to lie outside these bounds
We put forward a new explanation for the odd shape of the empirical pricing kernel, based on the notion of differential awareness
Summary
In the presence of such differential awareness of tail-risks, there is a range of feasible index option prices (both call and put) that give rise to non-monotonic pricing kernels. Show by example, that small differences in tail-risks as perceived by the two investor types can give rise to non-monotonic pricing kernels consistent with the observed evidence.
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