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Crash risk and risk neutral densities

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  • Chen, Ren-Raw
  • Hsieh, Pei-lin
  • Huang, Jeffrey

Abstract

“Crash risk” has been one of the major focuses in the recent asset pricing literature. Motivated by the recent literature that suggests an increase in crash risk since Fall 2008 and the recent troubles in the Euro zone, we use EUR/USD FX options for January 2, 2008 to March 18, 2015 to study option-implied risk-neutral densities (RND). We find that RND, especially higher moments, has superior explanatory power in predicting and explaining crash risk and its risk premiums. Furthermore, the higher moments of RND co-move closely with macroeconomic variables. Consistently, we find RND moments outperform the implied volatility from the Black–Scholes model.

Suggested Citation

  • Chen, Ren-Raw & Hsieh, Pei-lin & Huang, Jeffrey, 2018. "Crash risk and risk neutral densities," Journal of Empirical Finance, Elsevier, vol. 47(C), pages 162-189.
  • Handle: RePEc:eee:empfin:v:47:y:2018:i:c:p:162-189
    DOI: 10.1016/j.jempfin.2018.03.006
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    1. Abderrahmen Aloulou & Younes Boujelbene, 2019. "Dynamic analysis of implied risk neutral density," International Journal of Monetary Economics and Finance, Inderscience Enterprises Ltd, vol. 12(1), pages 39-58.

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    More about this item

    Keywords

    European crisis; Subprime crisis; Tail risk; Risk neutral density; FX option;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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