Disasters Implied by Equity Index Options

46 Pages Posted: 8 Sep 2009

See all articles by David K. Backus

David K. Backus

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Mikhail Chernov

UCLA Anderson

Ian Martin

London School of Economics & Political Science (LSE) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: August 2009

Abstract

We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with high-order cumulants: skewness, kurtosis, and so on. We show that high-order cumulants are quantitatively important in both representative-agent models with disasters and in a statistical pricing model estimated from equity index options. Option prices thus provide independent confirmation of the impact of extreme events on asset returns, but they imply a more modest distribution of them.

Keywords: cumulants, entropy, equity premium, implied volatility, pricing kernel, risk-neutral probabilities

JEL Classification: E44, G12

Suggested Citation

Backus, David K. and Chernov, Mikhail and Martin, Ian W. R., Disasters Implied by Equity Index Options (August 2009). CEPR Discussion Paper No. DP7416. Available at SSRN: https://ssrn.com/abstract=1469915

David K. Backus

NYU Stern School of Business

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HOME PAGE: http://pages.stern.nyu.edu/~dbackus/

National Bureau of Economic Research (NBER)

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HOME PAGE: http://pages.stern.nyu.edu/~dbackus/

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Ian W. R. Martin

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/martiniw/

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