Empirical pricing kernels obtained from the UK index options market

Abstract

Empirical pricing kernels for the UK equity market are derived as the ratio between risk-neutral densities, inferred from FTSE 100 index options, and historical real-world densities, estimated from time series of the index. The kernels thus obtained are almost compatible with a risk averse representative agent, unlike similar estimates for the US market.

Notes

¹ A vast literature has documented that option-implied volatility provides better forecasts of future volatilities than realized volatility. Poon and Granger (2003) and Taylor (2005) provide recent survey evidence. In terms of density forecasts, Liu et al. (2007) demonstrates that distributions from option prices are better forecasts than those obtained from asset price histories.