General Equilibrium Pricing of Options with Habit Formation and Event Risks
61 Pages Posted: 21 Dec 2009
Date Written: November 26, 2009
This paper proposes a preference-based general equilibrium model that explains the pricing of the S&P 500 index options since the 1987 market crash. The central ingredients are a peso component in the consumption growth rate and the time-varying risk aversion induced by habit formation that amplifies consumption shocks. The amplifying effect generates the excess volatility and a large jump-risk premium which combine to produce a pronounced volatility smirk for options written on the aggregate stock. The time-varying volatility and jump-risk premia enable the model to account for the state-dependent smirk patterns observed in the data as well. Besides volatility smirks, the model has a variety of other pricing implications, such as the high equity premium, the option term structure, and variations of price-dividend ratios across time, which are broadly consistent with the aggregate stock and option market data.
Keywords: habit formation, economic disasters, jump-risk premium, volatility smirk
JEL Classification: G01, G12, G13
Suggested Citation: Suggested Citation