Rare disaster probability and options pricing

Robert Barro and Gordon Y. Liao

Journal of Financial Economics, 2021, vol. 139, issue 3, 750-769

Abstract: We derive an options-pricing formula from recursive preferences and estimate rare disaster probability. The new options-pricing formula applies to far out-of-the-money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the economy has a representative agent with a constant-relative-risk-aversion utility function. The formula conforms with options data on the Standard & Poor's (S&P) 500 Index from 1983 to 2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the Global Financial Crisis, and forecasts rates of economic growth.

JEL-codes: E00 E10 E20 E27 G00 G01 G1 G12 G15 G17 (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (11)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:139:y:2021:i:3:p:750-769

DOI: 10.1016/j.jfineco.2020.10.001

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