Tractable Rare Disaster Probability and Options-Pricing

Robert Barro and Gordon Liao

No 2019-073, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We derive an option-pricing formula from recursive preference 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 Epstein-Zin utility. The formula conforms with options data on the S&P 500 index from 1983-2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the 2008-2009 financial crisis, and forecasts equity index returns and growth vulnerabilities in the economy.

Keywords: Disaster Probability; Option Prices; Rare Disaster; Tail Risk; Uncertainty; Volatility (search for similar items in EconPapers)
JEL-codes: E44 G12 G13 (search for similar items in EconPapers)
Pages: 55 pages
Date: 2019-09-27
New Economics Papers: this item is included in nep-mac, nep-rmg and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgfe:2019-73

DOI: 10.17016/FEDS.2019.073

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