Reference Dependent Preferences and the EPK Puzzle

Abstract

Supported by several recent investigations, the empirical pricing kernel (EPK) puzzle might be considered a stylized fact. Based on an economic model with state dependent preferences for the financial investors, we want to emphasize a microeconomic view that succeeds in explaining the puzzle. We retain the expected utility framework in a one period model and illustrate the case when the state is defined with respect to a reference point. We further investigate how the model relates the shape of the EPK to the economic conditions.

Optimal payoffs under state-dependent preferences

“…where g t is decreasing (in markets where E[S T ] > S 0 e rT ). There is empirical evidence that this relationship may not hold in practice, which is called the pricing kernel puzzle (Brown and Jackwerth (2004), Grith et al (2013)). Many explanations have been provided in the literature (Brown and Jackwerth (2004), Hens and Reichlin (2013)), including state-dependence of preferences (Chabi-Yo et al (2008)).…”

The Pricing Kernel Puzzle: Survey and Outlook

“…While such approach can be used in order to allow for flexible pricing kernels, which exhibit increasing sections, one should not take the model literally. Haerdle, Kraetschmer, and Moro (2009) was subsumed by Grith, Haerdle, and Kraetschmer (2015), who piece together the pricing kernel from many segments which (between referent points) are decreasing but can jump upwards at the reference points.…”