This paper examines the equilibrium when negative stock market jumps (crashes) can occur, and investors have heterogeneous attitudes towards crash risk. The less crash-averse insure the more crash-averse through the options markets that dynamically complete the economy. The resulting equilibrium is compared with various option pricing anomalies reported in the literature: the tendency of stock index options to overpredict volatility and jump risk, the Jackwerth (2000) implicit pricing kernel puzzle, and the stochastic evolution of option prices. The specification of crash aversion is compatible with the static option pricing puzzles, while heterogeneity partially explains the dynamic puzzles. Heterogeneity also magnifies substantially the stock market impact of adverse news about fundamentals.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
8557.
Length: Date of creation: Oct 2001 Date of revision: Handle: RePEc:nbr:nberwo:8557
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Find related papers by JEL classification: G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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