ELW pricing kernel and empirical risk aversion

Abstract

This study examines the pricing kernel and empirical risk aversion implied by Korea’s equity-linked warrants (ELWs). The estimated pricing kernel is clearly time-varying and exhibits a monotonic decrease with the underlying return state, which is consistent with mainstream economic theories on marginal utility. The movement of empirical risk aversion captures the economic conditions reflecting the recent global and liquidity crises. Particularly, empirical risk aversion has a highly significant relationship with the overall stock market return and credit spread change.

Keywords:

• pricing kernel
• risk aversion
• ELW

JEL Classification:

• G10
• G15
• G19

Notes

¹ The pricing of put ELWs is the same as that of call ELWs, except that the pay-off of put ELWs is max(K-S, 0).

² There are 56 estimation dates during our sample period. The estimation result of December 2008 is omitted.

³ The two months in which empirical risk aversion and one-month lagged empirical risk aversion are missing are dropped from the regression, thus leaving 54 observations.