A Non-Linear Market Model

This paper estimates a single pricing factor from index options and shows that it can explain a large set of prominent stock return anomalies jointly. A key feature of the new pricing factor is that it is a U-shaped function of index returns, implying that investors demand an upside risk premium. The upside risk premium is sizable and crucial for the success of the pricing factor. Moreover, I document that the pricing factor can also price other prominent asset classes such as international equities, options and commodities, again with a sizable premium for upside risk exposure. The results can be explained with a compensation for exposure to systematic variance risk