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Explaining asset pricing puzzles associated with the 1987 market crash

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  • Luca Benzoni
  • Pierre Collin-Dufresne
  • Robert S. Goldstein
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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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    File URL: http://www.chicagofed.org/digital_assets/publications/working_papers/2010/wp2010_10.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-2010-10.

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    Date of creation: 2010
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    Handle: RePEc:fip:fedhwp:wp-2010-10

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    Keywords: Asset pricing ; Prices ; Markets;

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    1. Yacine Ait-Sahalia & Andrew W. Lo, 2000. "Nonparametric Risk Management and Implied Risk Aversion," NBER Working Papers 6130, National Bureau of Economic Research, Inc.
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