Option Prices in a Model with Stochastic Disaster Risk

Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model ass...

Full description

Saved in:
Bibliographic Details
Published in:Management science 2019-08, Vol.65 (8), p.3449-3469
Main Authors: Seo, Sang Byung, Wachter, Jessica A
Format: Article
Language:English
Subjects:
Asset pricing
Consumption
consumption disasters
Disasters
implied volatilities
jump diffusions
kurtosis
Options (Finance)
Prices
Risk assessment
Securities markets
Securities prices
Stochastic models
Stock markets
Volatility
Citations: Items that this one cites
Items that cite this one
Online Access:Get full text
Tags: Add Tag
No Tags, Be the first to tag this record!
Description
Summary:Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model assumes a small risk of economic disaster that is calibrated based on international data on large consumption declines. We allow the disaster probability to be stochastic, which turns out to be crucial to the model’s ability both to match equity volatility and to reconcile option prices with macroeconomic data on disasters. This paper was accepted by Lauren Cohen, finance.
ISSN:0025-1909
1526-5501
DOI:10.1287/mnsc.2017.2978