The Pricing Kernel Puzzle: Reconciling Index Option Data and Economic Theory

The pricing kernel puzzle of Jackwerth (2000) concerns the fact that the empirical pricing kernel implied in S&P 500 index options and index returns is not monotonically decreasing in wealth as standard economic theory would suggest. Thus, those options are currently priced in a way such that any risk-averse investor would increase his utility by trading in them. We discuss the limited literature, which deals with the puzzle directly, but find that those papers cannot explain the puzzle, either. We provide a novel representative agent model where volatility is a function of a second momentum state variable. This model is capable of generating the empirical patterns in the pricing kernel, albeit only for parameter constellations which are not typically observed in the real world.