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Y. Liu, F. Chabi-Yo, & J. Du: Distorting Arrow-Debreu Securities: New Entropy Restrictions Implied by the Option Cross-Section *

August 15, 2025

Replacing equity return (as in the equity risk premium) with returns on an arbitrary contingent claim, we obtain a new continuum of economic risk premiums to impose upon candidate models. These risk premiums reflect the distance between the physical and risk-neutral moments of asset returns, can be estimated model-free from the option cross-section, and provide sharp information in distinguishing alternative models. We uncover a wide dispersion in performance across leading macro-finance models, confronting them with our risk premiums. Our evidence highlights the importance of incorporating persistent stochastic volatilities and/or higher moments in fundamentals to reconcile with the option data.

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