Tails, Fears, and Equilibrium Option Prices

60 Pages Posted: 22 Nov 2013 Last revised: 24 Jul 2014

Date Written: July 23, 2014

Abstract

Recent empirical evidence suggests that the compensation for rare events accounts for a large fraction of the average equity and variance premia. I replicate this fact in a parsimonious consumption-based asset pricing model based on a (generalized) disappointment averse investor and conditionally Gaussian fundamentals. In the model, regime-switches in endowment volatility interact with the investor's tail aversion to produce large endogenous return jumps and a realistic implied volatility smirk. The presence of multiple shock frequencies in volatility gives the variance premium the ability to predict returns over short horizons and the price-dividend ratio the ability to predict returns over long horizons.

Keywords: Generalized Disappointment Aversion, Equity Index Options, Varience Swaps, Return Predictability

Suggested Citation

Schreindorfer, David, Tails, Fears, and Equilibrium Option Prices (July 23, 2014). Available at SSRN: https://ssrn.com/abstract=2358157 or http://dx.doi.org/10.2139/ssrn.2358157

David Schreindorfer (Contact Author)

Arizona State University ( email )

United States

HOME PAGE: http://www.davidschreindorfer.com

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