Option Prices in a Model with Stochastic Disaster Risk
67 Pages Posted: 26 Jan 2015 Last revised: 22 Nov 2017
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: Suggested Citation