An Equilibrium Model of Rare-Event Premia and Its Implication for Option Smirks

Jun Liu

The Review of Financial Studies, 2005, vol. 18, issue 1, 131-164

Abstract: This article studies the asset pricing implication of imprecise knowledge about rare events. Modeling rare events as jumps in the aggregate endowment, we explicitly solve the equilibrium asset prices in a pure-exchange economy with a representative agent who is averse not only to risk but also to model uncertainty with respect to rare events. The equilibrium equity premium has three components: the diffusive- and jump-risk premiums, both driven by risk aversion; and the "rare-event premium," driven exclusively by uncertainty aversion. To disentangle the rare-event premiums from the standard risk-based premiums, we examine the equilibrium prices of options across moneyness or, equivalently, across varying sensitivities to rare events. We find that uncertainty aversion toward rare events plays an important role in explaining the pricing differentials among options across moneyness, particularly the prevalent "smirk" patterns documented in the index options market. Copyright 2005, Oxford University Press.

Date: 2005
References: Add references at CitEc
Citations: View citations in EconPapers (162)

Downloads: (external link)
http://hdl.handle.net/10.1093/rfs/hhi011 (text/html)
Access to full text is restricted to subscribers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:oup:rfinst:v:18:y:2005:i:1:p:131-164

Ordering information: This journal article can be ordered from
https://academic.oup.com/journals

Access Statistics for this article

The Review of Financial Studies is currently edited by Itay Goldstein

More articles in The Review of Financial Studies from Society for Financial Studies Oxford University Press, Journals Department, 2001 Evans Road, Cary, NC 27513 USA.. Contact information at EDIRC.
Bibliographic data for series maintained by Oxford University Press (joanna.bergh@oup.com).