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Essays on capital markets: Application of pricing kernels to derivatives pricing and asset allocation

Jin Gyoon Jung, University of Massachusetts - Amherst

Abstract

This dissertation is comprised of four related essays on capital markets. The essays are based on the application of pricing kernels to build mathematical models and financial econometric estimation for asset pricing, derivative pricing, and asset allocation. ^ In the first essay, we propose a new way of modeling and estimating pricing kernels. Our model is a multi-factor version, which includes stochastic volatility and the central tendency of a state variable. It shows that equity prices contain information about bond prices. We prove that in the bond price valuation process, there is no information involved for the equity prices, but equity price valuation does include bond prices as a state variable. ^ The second essay studies the behavior of market price of risk (MPR) from interest rate process and apply the estimated MPR for derivatives pricing. In this essay, we empirically study the behavior of MPR using the volatility of long term bonds' return under a certain limiting probability condition. We test the proposed method with the CIR single factor model. Empirical work is also extended to compare theoretical model prices of zero-coupon bonds and derivatives with the estimated MPR. ^ In the third essay, we investigate the behavior of the MPR estimated from the market data and simulated data. The new proposed model of the MPR is based on the volatility structure of long term bond returns. We simulate the term structure of volatility for the very long-term bonds and compare the results with the available market data. Furthermore, we find that the short-term interest rates and its volatility affect positively on the changes in the level of MPR. As a factor analysis, the volatility of the short-term interest rates influence more significantly on the MPR than the short-term interest rates do. ^ The fourth essay proposes an optimal growth portfolio model using long-term bonds to find optimum asset allocation strategy. We test the effect of changes in the optimal growth portfolio using risk-less assets and market portfolio and find optimal asset allocation strategy. We test the performance of the long-term bonds as a proxy for the optimal growth portfolio. ^

Subject Area

Economics, Finance

Recommended Citation

Jin Gyoon Jung, "Essays on capital markets: Application of pricing kernels to derivatives pricing and asset allocation" (January 1, 2000). Doctoral Dissertations Available from Proquest. Paper AAI9988804.
http://scholarworks.umass.edu/dissertations/AAI9988804

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