General equilibrium pricing of options with habit formation and event risks

Du Du

Journal of Financial Economics, 2011, vol. 99, issue 2, 400-426

Abstract: This paper proposes a general equilibrium model that explains the pricing of the S&P 500 index options. The central ingredients are a peso component in the consumption growth rate and the time-varying risk aversion induced by habit formation which amplifies consumption shocks. The amplifying effect generates the excess volatility and a large jump-risk premium which combine to produce a pronounced volatility smirk for index options. The time-varying volatility and jump-risk premiums explain the observed state-dependent smirk patterns. Besides volatility smirks, the model has a variety of other implications which are broadly consistent with the aggregate stock and option market data.

Keywords: Habit; formation; Economic; disasters; Jump-risk; premium; Volatility; smirk (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (14)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:99:y:2011:i:2:p:400-426

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