Les Cahiers de Recherche - HEC Paris
Pricing kernels and dynamic portfolios
Abstract: We investigate the structure of the pricing kernels in a
general dynamic investment setting by making use of their duality with the
self financing portfolios. We generalize the variance bound on the
intertemporal marginal rate of substitution introduced in Hansen and
Jagannathan (1991) along two dimensions, first by looking at the variance
of the pricing kernels over several trading periods, and second by studying
the restrictions imposed by the market prices of a set of securities.
The variance bound is the square of the optimal Sharpe ratio which can be
achieved through a dynamic self financing strategy. This Sharpe ratio may
be further enhanced by investing dynamically in some additional securities.
We exhibit the kernel which yields the smallest possible increase in
optimal dynamic Sharpe ratio while agreeing with the current market quotes
of the additional instruments.
Keywords: pricing kernel; Sharpe ratio; self financing portfolio; variance-optimal hedging; (follow links to similar papers)
JEL-Codes: E44; G11; (follow links to similar papers)
61 pages, August 16, 2002
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