Isolating the disaster risk premium with equity options

Jaroslav Horvath

Journal of Empirical Finance, 2019, vol. 51, issue C, 138-148

Abstract: The US equity risk premium is approximated with a mean unhedged equity return. I utilize out-of-the-money put options to obtain a hedged equity return, which allows me to quantify the disaster risk premium as the difference between the means of unhedged and hedged equity returns. I demonstrate that a substantial fraction of the U.S. equity risk premium over the period from 1996 to 2016 is attributed to disasters defined as stock price depreciations below a pre-specified strike price. Employing alternative hedging schemes increases the contribution of disasters to the equity risk premium.

Keywords: Disasters; Equity risk premium; Jumps; Options (search for similar items in EconPapers)
JEL-codes: E21 G11 G12 (search for similar items in EconPapers)
Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:51:y:2019:i:c:p:138-148

DOI: 10.1016/j.jempfin.2019.02.005

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