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Testing market efficiency with the pricing kernel

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  • Giovanni Barone-Adesi
  • Carlo Sala

Abstract

Market efficiency and the pricing kernel are closely related. A non-monotonic decreasing pricing kernel implies the existence of a trading strategy in contingent claims that stochastically dominates a direct investment in the market. Moreover, a market is assumed to be efficient only if no dominating strategies exist. Empirically, many studies of the pricing kernel find non-monotonicity, apparently ruling out market efficiency. However, these results are often unreliable, because the pricing measures of the pricing kernel are estimated using differing filtration sets. We show this effect both theoretically and empirically, and we discuss recent approaches in the literature for achieving more reliable estimates of the pricing kernel, potentially leading to better tests of market efficiency.

Suggested Citation

  • Giovanni Barone-Adesi & Carlo Sala, 2019. "Testing market efficiency with the pricing kernel," The European Journal of Finance, Taylor & Francis Journals, vol. 25(13), pages 1166-1193, September.
    • Handle: RePEc:taf:eurjfi:v:25:y:2019:i:13:p:1166-1193
    DOI: 10.1080/1351847X.2019.1581638
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    Cited by:

    1. Barone-Adesi, Giovanni & Fusari, Nicola & Mira, Antonietta & Sala, Carlo, 2020. "Option market trading activity and the estimation of the pricing kernel: A Bayesian approach," Journal of Econometrics, Elsevier, vol. 216(2), pages 430-449.
    2. José Carlos Dias & João Pedro Vidal Nunes & Aricson Cruz, 2020. "A note on options and bubbles under the CEV model: implications for pricing and hedging," Review of Derivatives Research, Springer, vol. 23(3), pages 249-272, October.

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