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Differential Awareness of Rare Disasters and the Pricing Kernel Puzzle

Risk-averse expected utility maximization implies that the pricing kernel must be a non-increasing function of aggregate wealth. However, empirical research has found that the pricing kernel frequently displays a locally increasing portion in aggregate wealth. This is known as the pricing kernel puzzle. In this article, we show that if there is differential awareness of rare disasters, then there exists a range of feasible option prices that produce a locally increasing pricing kernel similar to the empirically observed pricing kernel. We show, by example, that even tiny differences in state spaces as perceived by option and equity traders are sufficient to generate a non-monotonic pricing kernel.