The Missing Tail Risk in Option Prices

Jason Brown, Nida Çakır Melek, Johannes Matschke and Sai Sattiraju

No RWP 23-02, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: This paper contributes to the literature on deviations from rational expectations in financial markets and to the literature on evaluating density forecasts. We first develop a novel statistic to evaluate the overall accuracy of distributional forecasts, and find two methods that yield accurate distributional forecasts. We then propose another statistic to examine the relative accuracy over the entire distribution range. Our results indicate more oil price realizations in the left tail than predicted. We argue that this finding points to a persistent behavioral forecasting bias and a departure from the rational expectations hypothesis. Investors hence underestimate left tail risk and under-insure against very low oil prices.

Keywords: option pricing; density forecasts; tail risks (search for similar items in EconPapers)
JEL-codes: C52 C58 G12 G17 G41 Q47 (search for similar items in EconPapers)
Pages: 43
Date: 2023-03-31
New Economics Papers: this item is included in nep-des and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedkrw:96072

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DOI: 10.18651/RWP2023-02

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