Option Prices in a Model with Stochastic Disaster Risk

67 Pages Posted: 26 Jan 2015 Last revised: 22 Nov 2017

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)

Multiple version iconThere are 3 versions of this paper

Date Written: October 3, 2017


Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model assumes a small risk of economic disaster that is calibrated based on international data on large consumption declines. We allow the disaster probability to be stochastic, which turns out to be crucial to the model's ability both to match equity volatility and to reconcile option prices with macroeconomic data on disaster.

Keywords: implied volatilities, consumption disasters, jump-diffusions

JEL Classification: G12, G13

Suggested Citation

Seo, Sang Byung and Wachter, Jessica A., Option Prices in a Model with Stochastic Disaster Risk (October 3, 2017). The Wharton School Research Paper No. 76. Available at SSRN: https://ssrn.com/abstract=2555700

Sang Byung Seo

University of Wisconsin - Madison ( email )

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Jessica A. Wachter (Contact Author)

University of Pennsylvania - Finance Department ( email )

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