Option Prices in a Model with Stochastic Disaster Risk

Sang Byung Seo () and Jessica A. Wachter ()
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Sang Byung Seo: University of Houston, Houston, Texas 77204
Jessica A. Wachter: University of Pennsylvania, Philadelphia, Pennsylvania 19104; and National Bureau of Economic Research, Cambridge, Massachusetts 02138

Management Science, 2019, vol. 65, issue 8, 3449-3469

Abstract: Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model assumes a small risk of economic disaster that is calibrated based on international data on large consumption declines. We allow the disaster probability to be stochastic, which turns out to be crucial to the model’s ability both to match equity volatility and to reconcile option prices with macroeconomic data on disasters.

Keywords: implied volatilities; consumption disasters; kurtosis; jump diffusions (search for similar items in EconPapers)
Date: 2019
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Citations: View citations in EconPapers (25)

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