Hedging jump risk, expected returns and risk premia in jump-diffusion economies

Oliver X. Li and Weiping Li

Quantitative Finance, 2015, vol. 15, issue 5, 873-888

Abstract: This article presents a pure exchange economy that extends Rubinstein [ Bell J. Econ. Manage. Sci. , 1976, 7 , 407-425] to show how the jump-diffusion option pricing model of Black and Scholes [ J. Political Econ. , 1973, 81 , 637-654] and Merton [ J. Financ. Econ. , 1976, 4 , 125-144] evolves in gamma jumping economies. From empirical analysis and theoretical study, both the aggregate consumption and the stock price are unknown in determining jumping times. By using the pricing kernel, we determine both the aggregate consumption jump time and the stock price jump time from the equilibrium interest rate and CCAPM (Consumption Capital Asset Pricing Model). Our general jump-diffusion option pricing model gives an explicit formula for how the jump process and the jump times alter the pricing. This innovation with predictable jump times enhances our analysis of the expected stock return in equilibrium and of hedging jump risks for jump-diffusion economies.

Date: 2015
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DOI: 10.1080/14697688.2014.946439

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