The Risk and Return of Equity and Credit Index Options
51 Pages Posted: 14 Jul 2021 Last revised: 22 Jan 2024
Date Written: January 20, 2024
We develop a structural credit risk model, which allows us to price equity/credit indices and their options through the asset dynamics of index constituents. We estimate the model via MLE and find that equity and credit index option prices are well explained out-of-sample. Contrary to recent empirical findings, the two option markets are not inconsistently priced through the lens of our model. Returns on both options, while extreme, do not indicate any evidence of mispricing. Our analysis suggests that jointly addressing the pricing of various instruments requires a balance between three sources of systematic risk: asset, variance, and jump risks.
JEL Classification: G12, G13
Suggested Citation: Suggested Citation