General Equilibrium Pricing of Options with Habit Formation and Event Risks
61 Pages Posted: 21 Dec 2009
Date Written: November 26, 2009
Abstract
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
Do you have negative results from your research you’d like to share?
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