General equilibrium pricing of options with habit formation and event risks
AbstractThis paper proposes a general equilibrium model that explains the pricing of the S&P 500 index options. The central ingredients are a peso component in the consumption growth rate and the time-varying risk aversion induced by habit formation which amplifies consumption shocks. The amplifying effect generates the excess volatility and a large jump-risk premium which combine to produce a pronounced volatility smirk for index options. The time-varying volatility and jump-risk premiums explain the observed state-dependent smirk patterns. Besides volatility smirks, the model has a variety of other implications which are broadly consistent with the aggregate stock and option market data.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Financial Economics.
Volume (Year): 99 (2011)
Issue (Month): 2 (February)
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Web page: http://www.elsevier.com/locate/inca/505576
Habit formation Economic disasters Jump-risk premium Volatility smirk;
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