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The market for crash risk

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  • Bates, David S.

Abstract

This paper examines the equilibrium when stock market crashes can occur and investors have heterogeneous attitudes towards crash risk. The less crash averse insure the more crash averse through options markets that dynamically complete the economy. The resulting equilibrium is compared with various option pricing anomalies: the tendency of stock index options to overpredict volatility and jump risk, the Jackwerth [Recovering risk aversion from option prices and realized returns. Review of Financial Studies 13, 433-451] implicit pricing kernel puzzle, and the stochastic evolution of option prices. Crash aversion is compatible with some static option pricing puzzles, while heterogeneity partially explains dynamic puzzles. Heterogeneity also magnifies substantially the stock market impact of adverse news about fundamentals.

Suggested Citation

  • Bates, David S., 2008. "The market for crash risk," Journal of Economic Dynamics and Control, Elsevier, vol. 32(7), pages 2291-2321, July.
  • Handle: RePEc:eee:dyncon:v:32:y:2008:i:7:p:2291-2321
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