How Bad Will the Potential Economic Disasters Be? Evidences from S&P 500 Index Options Data

65 Pages Posted: 25 Jun 2008

See all articles by Du Du

Du Du

Hong Kong University of Science & Technology (HKUST)

Date Written: June 18, 2008

Abstract

This paper proposes a new methodology of using the S&P 500 index option data to gauge the magnitudes of the potential economic disasters in the U.S. with a setup incorporating a small-probability consumption jump and habit formation. The estimated economic disasters strike once every 36-64 years in the form of 13.5-17.6% consumption contractions, which induce 36-56% stock market crashes. These results are much more in line with the empirical observations than those estimated with Peso problem models in which habit formation is ignored. The setup also explains a wide variety of the observed pricing features of both options and stocks.

Keywords: economic disasters, habit formation, volatility smirk, equity premium

JEL Classification: G10, G12

Suggested Citation

Du, Du, How Bad Will the Potential Economic Disasters Be? Evidences from S&P 500 Index Options Data (June 18, 2008). Available at SSRN: https://ssrn.com/abstract=1150472 or http://dx.doi.org/10.2139/ssrn.1150472

Du Du (Contact Author)

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong

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