Advanced Search
MyIDEAS: Login

Explaining asset pricing puzzles associated with the 1987 market crash

Contents:

Author Info

  • Benzoni, Luca
  • Collin-Dufresne, Pierre
  • Goldstein, Robert S.
Registered author(s):

    Abstract

    The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features of individual stock options, equity returns, and interest rates.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X11000328
    Download Restriction: Full text for ScienceDirect subscribers only

    As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 101 (2011)
    Issue (Month): 3 (September)
    Pages: 552-573

    as in new window
    Handle: RePEc:eee:jfinec:v:101:y:2011:i:3:p:552-573

    Contact details of provider:
    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Volatility smile Volatility smirk Implied volatility Option pricing Portfolio insurance;

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. Attanasio, Orazio P & Weber, Guglielmo, 1989. "Intertemporal Substitution, Risk Aversion and the Euler Equation for Consumption," Economic Journal, Royal Economic Society, vol. 99(395), pages 59-73, Supplemen.
    2. Beeler, Jason & Campbell, John Y., 2012. "The Long-Run Risks Model and Aggregate Asset Prices: An Empirical Assessment," Critical Finance Review, now publishers, vol. 1(1), pages 141-182, January.
    3. Dennis, Patrick & Mayhew, Stewart, 2002. "Risk-Neutral Skewness: Evidence from Stock Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(03), pages 471-493, September.
    4. Nicolae Garleanu & Lasse Heje Pedersen & Allen M. Poteshman, 2009. "Demand-Based Option Pricing," Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 4259-4299, October.
    5. Tim Bollerslev & Hao Zhou, 2006. "Expected stock returns and variance risk premia," Finance and Economics Discussion Series 2007-11, Board of Governors of the Federal Reserve System (U.S.).
    6. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 50(5), pages 1269-86, September.
    7. T. Clifton Green & Stephen Figlewski, 1999. "Market Risk and Model Risk for a Financial Institution Writing Options," Journal of Finance, American Finance Association, vol. 54(4), pages 1465-1499, 08.
    8. Figlewski, Stephen, 1989. " Options Arbitrage in Imperfect Markets," Journal of Finance, American Finance Association, vol. 44(5), pages 1289-1311, December.
    9. Duffie, Darrell & Epstein, Larry G, 1992. "Stochastic Differential Utility," Econometrica, Econometric Society, vol. 60(2), pages 353-94, March.
    10. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-57, April.
    11. Schroder, Mark & Skiadas, Costis, 1999. "Optimal Consumption and Portfolio Selection with Stochastic Differential Utility," Journal of Economic Theory, Elsevier, vol. 89(1), pages 68-126, November.
    12. Garcia, Rene & Luger, Richard & Renault, Eric, 2003. "Empirical assessment of an intertemporal option pricing model with latent variables," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 49-83.
    13. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
    14. Mark Fisher & Christian Gilles, 1999. "Consumption and asset prices with homothetic recursive preferences," Working Paper 99-17, Federal Reserve Bank of Atlanta.
    15. Jacob Boudoukh & Roni Michaely & Matthew Richardson & Michael Roberts, 2004. "On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing," NBER Working Papers 10651, National Bureau of Economic Research, Inc.
    16. George Chacko & Luis M. Viceira, 2005. "Dynamic Consumption and Portfolio Choice with Stochastic Volatility in Incomplete Markets," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1369-1402.
    17. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    18. Jackwerth, Jens Carsten, 2000. "Recovering Risk Aversion from Option Prices and Realized Returns," Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 433-51.
    19. Pietro Veronesi, . "How Does Information Quality Affect Stock Returns?," CRSP working papers 361, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    20. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 1997. " Empirical Performance of Alternative Option Pricing Models," Journal of Finance, American Finance Association, vol. 52(5), pages 2003-49, December.
    21. Nicolas P. B. Bollen & Robert E. Whaley, 2004. "Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?," Journal of Finance, American Finance Association, vol. 59(2), pages 711-753, 04.
    22. Duffie, Darrel & Lions, Pierre-Louis, 1992. "PDE solutions of stochastic differential utility," Journal of Mathematical Economics, Elsevier, vol. 21(6), pages 577-606.
    23. Bjørn Eraker, 2004. "Do Stock Prices and Volatility Jump? Reconciling Evidence from Spot and Option Prices," Journal of Finance, American Finance Association, vol. 59(3), pages 1367-1404, 06.
    24. Duffie, Darrell & Skiadas, Costis, 1994. "Continuous-time security pricing : A utility gradient approach," Journal of Mathematical Economics, Elsevier, vol. 23(2), pages 107-131, March.
    25. David M Kreps & Evan L Porteus, 1978. "Temporal Resolution of Uncertainty and Dynamic Choice Theory," Levine's Working Paper Archive 625018000000000009, David K. Levine.
    26. Bates, David S., 2000. "Post-'87 crash fears in the S&P 500 futures option market," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 181-238.
    27. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
    28. Bates, David S., 2008. "The market for crash risk," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2291-2321, July.
    29. Fousseni Chabi-Yo & René Garcia & Eric Renault, 2008. "State Dependence Can Explain the Risk Aversion Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 973-1011, April.
    30. Bjørn Eraker, 2008. "Affine General Equilibrium Models," Management Science, INFORMS, vol. 54(12), pages 2068-2080, December.
    31. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
    32. Joshua D. Coval, 2001. "Expected Option Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 983-1009, 06.
    33. Jun Liu, 2004. "Losing Money on Arbitrage: Optimal Dynamic Portfolio Choice in Markets with Arbitrage Opportunities," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 611-641.
    34. Longstaff, Francis A, 1995. "Option Pricing and the Martingale Restriction," Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 1091-1124.
    35. Mark Broadie & Mikhail Chernov & Michael Johannes, 2007. "Model Specification and Risk Premia: Evidence from Futures Options," Journal of Finance, American Finance Association, vol. 62(3), pages 1453-1490, 06.
    36. Ravi Bansal & A. Ronald Gallant & George Tauchen, 2007. "Rational Pessimism, Rational Exuberance, and Asset Pricing Models," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1005-1033.
    37. Jones, Christopher S., 2003. "The dynamics of stochastic volatility: evidence from underlying and options markets," Journal of Econometrics, Elsevier, vol. 116(1-2), pages 181-224.
    38. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm54, Yale School of Management.
    39. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    40. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    41. Duffie, Darrell & Epstein, Larry G, 1992. "Asset Pricing with Stochastic Differential Utility," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 411-36.
    42. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
    43. Pietro Veronesi, . "How Does Information Quality Affect Stock Returns?," CRSP working papers 462, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    44. Rosenberg, Joshua V. & Engle, Robert F., 2002. "Empirical pricing kernels," Journal of Financial Economics, Elsevier, vol. 64(3), pages 341-372, June.
    45. Joost Driessen & Pascal Maenhout, 2007. "An Empirical Portfolio Perspective on Option Pricing Anomalies," Review of Finance, European Finance Association, vol. 11(4), pages 561-603.
    46. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
    47. Veronesi, Pietro, 1999. "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 975-1007.
    48. Bing Han, 2008. "Investor Sentiment and Option Prices," Review of Financial Studies, Society for Financial Studies, vol. 21(1), pages 387-414, January.
    49. Andrea Buraschi & Alexei Jiltsov, 2006. "Model Uncertainty and Option Markets with Heterogeneous Beliefs," Journal of Finance, American Finance Association, vol. 61(6), pages 2841-2897, December.
    50. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, January.
    51. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
    52. Chernov, Mikhail & Ghysels, Eric, 2000. "A study towards a unified approach to the joint estimation of objective and risk neutral measures for the purpose of options valuation," Journal of Financial Economics, Elsevier, vol. 56(3), pages 407-458, June.
    53. Santa-Clara, Pedro & Saretto, Alessio, 2009. "Option strategies: Good deals and margin calls," Journal of Financial Markets, Elsevier, vol. 12(3), pages 391-417, August.
    54. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
    55. Rubinstein, Mark, 1994. " Implied Binomial Trees," Journal of Finance, American Finance Association, vol. 49(3), pages 771-818, July.
    56. Bjørn Eraker & Ivan Shaliastovich, 2008. "An Equilibrium Guide To Designing Affine Pricing Models," Mathematical Finance, Wiley Blackwell, vol. 18(4), pages 519-543.
    57. Liu, Jun & Pan, Jun, 2003. "Dynamic Derivative Strategies," Working papers 4334-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    58. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm65, Yale School of Management.
    59. Pietro Veronesi, 2000. "How Does Information Quality Affect Stock Returns?," Journal of Finance, American Finance Association, vol. 55(2), pages 807-837, 04.
    60. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 2000. "Pricing and hedging long-term options," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 277-318.
    61. David, Alexander, 1997. "Fluctuating Confidence in Stock Markets: Implications for Returns and Volatility," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(04), pages 427-462, December.
    62. Schroder, Mark & Skiadas, Costis, 2003. "Optimal lifetime consumption-portfolio strategies under trading constraints and generalized recursive preferences," Stochastic Processes and their Applications, Elsevier, vol. 108(2), pages 155-202, December.
    63. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    64. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-20, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as in new window

    Cited by:
    1. Sang Byung Seo & Jessica A. Wachter, 2013. "Option Prices in a Model with Stochastic Disaster Risk," NBER Working Papers 19611, National Bureau of Economic Research, Inc.
    2. David Backus & Mikhail Chernov & Stanley Zin, 2011. "Sources of Entropy in Representative Agent Models," Working Papers 11-21, New York University, Leonard N. Stern School of Business, Department of Economics.
    3. Luca Benzoni & Pierre Collin-Dufresne & Robert S. Goldstein & Jean Helwege, 2012. "Modeling credit contagion via the updating of fragile beliefs," Working Paper Series WP-2012-04, Federal Reserve Bank of Chicago.
    4. Peter Christoffersen & Du Du & Redouane Elkamhi, 2013. "Rare Disasters and Credit Market Puzzles," CREATES Research Papers 2013-45, School of Economics and Management, University of Aarhus.
    5. Pierre Collin-Dufresne & Michael Johannes & Lars A. Lochstoer, 2013. "Parameter Learning in General Equilibrium: The Asset Pricing Implications," NBER Working Papers 19705, National Bureau of Economic Research, Inc.
    6. Bryan Kelly & Lubos Pastor & Pietro Veronesi, 2014. "The Price of Political Uncertainty: Theory and Evidence from the Option Market," NBER Working Papers 19812, National Bureau of Economic Research, Inc.
    7. Du, Du, 2013. "General equilibrium pricing of currency and currency options," Journal of Financial Economics, Elsevier, vol. 110(3), pages 730-751.
    8. Andras Fulop & Junye Li & Jun Yu, 2012. "Investigating Impacts of Self-Exciting Jumps in Returns and Volatility: A Bayesian Learning Approach," Global COE Hi-Stat Discussion Paper Series gd12-264, Institute of Economic Research, Hitotsubashi University.
    9. Branger, Nicole & Grüning, Patrick & Kraft, Holger & Meinerding, Christoph, 2013. "Asset pricing under uncertainty about shock propagation," SAFE Working Paper Series 34, Center of Excellence SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:eee:jfinec:v:101:y:2011:i:3:p:552-573. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.