Option Prices in a Model with Stochastic Disaster Risk

71 Pages Posted: 22 Oct 2013

See all articles by Sang Byung Seo

Sang Byung Seo

University of Wisconsin - Madison

Jessica A. Wachter

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

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Date Written: June 30, 2014

Abstract

  Large rare shocks to aggregate consumption, namely, disasters, have been proposed as an explanation for the equity premium. However, recent work suggests that the consumption distribution required by this mechanism is inconsistent with the average implied volatility curve derived from option prices. We show that this apparent inconsistency can be resolved in a model with stochastic disaster risk. That is, we show that a model with a stochastic probability of disaster can explain average implied volatil- ities, despite being calibrated to consumption and aggregate market data alone. We also extend the stochastic disaster risk model to one that allows for variation in the risk of disaster at different time scales. We show that this extension allows the model to match variation in the level and slope of implied volatilities, as well as the average implied volatility curve.   

Suggested Citation

Seo, Sang Byung and Wachter, Jessica A., Option Prices in a Model with Stochastic Disaster Risk (June 30, 2014). The Wharton School Research Paper No. 55. Available at SSRN: https://ssrn.com/abstract=2343707

Sang Byung Seo (Contact Author)

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Jessica A. Wachter

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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