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Explaining asset pricing puzzles associated with the 1987 market crash

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  • Benzoni, Luca
  • Collin-Dufresne, Pierre
  • Goldstein, Robert S.
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    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.

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    Bibliographic Info

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

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

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    Handle: RePEc:eee:jfinec:v:101:y:2011:i:3:p:552-573

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

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

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    Cited by:
    1. David Backus & Mikhail Chernov & Stanley E. Zin, 2011. "Sources of Entropy in Representative Agent Models," NBER Working Papers 17219, National Bureau of Economic Research, Inc.
    2. Branger, Nicole & Grüning, Patrick & Kraft, Holger & Meinerding, Christoph, 2013. "Asset pricing under uncertainty about shock propagation," SAFE Working Paper Series 34, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    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. Kelly, Bryan & Pástor, Luboš & Veronesi, Pietro, 2014. "The Price of Political Uncertainty: Theory and Evidence from the Option Market," CEPR Discussion Papers 9822, C.E.P.R. Discussion Papers.
    5. Jerry Tsai & Jessica A. Wachter, 2014. "Rare Booms and Disasters in a Multi-sector Endowment Economy," NBER Working Papers 20062, National Bureau of Economic Research, Inc.
    6. Du, Du, 2013. "General equilibrium pricing of currency and currency options," Journal of Financial Economics, Elsevier, vol. 110(3), pages 730-751.
    7. 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.
    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. 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.
    10. 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.

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