How Bad Will the Potential Economic Disasters Be? Evidences from S&P 500 Index Options Data
65 Pages Posted: 25 Jun 2008
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: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
Consumption, Aggregate Wealth and Expected Stock Returns
By Martin Lettau and Sydney C. Ludvigson
-
Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles
By Ravi Bansal and Amir Yaron
-
Dividend Yields and Expected Stock Returns: Alternative Procedures for Interference and Measurement
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia are Time-Varying
By Martin Lettau and Sydney C. Ludvigson
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Stock Return Predictability: Is it There?
By Geert Bekaert and Andrew Ang
-
Resurrecting the (C)Capm: A Cross-Sectional Test When Risk Premia Wre Time-Varying
By Martin Lettau and Sydney C. Ludvigson