Dampened Power Law: Reconciling the Tail Behavior of Financial Security Returns

Liuren Wu ()

Journal of Business, 2006, vol. 79, issue 3, pages 1445-1474

Abstract: This article proposes a stylized model that reconciles several seemingly conflicting findings on financial security returns and option prices. The model is based on a pure jump Lévy process, wherein the jump arrival rate obeys a power law dampened by an exponential function. The model allows for different degrees of dampening for positive and negative jumps and also for different pricing for upside and downside market risks. Calibration of the model to the S&P 500 index shows that the market charges only a moderate premium on upward index movements but the maximally allowable premium on downward index movements.

Date: 2006
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Working Paper: Dampened Power Law: Reconciling the Tail Behavior of Financial Security Returns (2004)
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