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Rare disaster probability and options pricing

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  • Barro, Robert J.
  • Liao, Gordon Y.

Abstract

We derive an options-pricing formula from recursive preferences and estimate rare disaster probability. The new options-pricing formula applies to far out-of-the-money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the economy has a representative agent with a constant-relative-risk-aversion utility function. The formula conforms with options data on the Standard & Poor's (S&P) 500 Index from 1983 to 2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the Global Financial Crisis, and forecasts rates of economic growth.

Suggested Citation

  • Barro, Robert J. & Liao, Gordon Y., 2021. "Rare disaster probability and options pricing," Journal of Financial Economics, Elsevier, vol. 139(3), pages 750-769.
    • Handle: RePEc:eee:jfinec:v:139:y:2021:i:3:p:750-769
    DOI: 10.1016/j.jfineco.2020.10.001
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    6. Carverhill, Andrew & Luo, Dan, 2023. "A Bayesian analysis of time-varying jump risk in S&P 500 returns and options," Journal of Financial Markets, Elsevier, vol. 64(C).
    7. Battauz, Anna & De Donno, Marzia & Sbuelz, Alessandro, 2022. "On the exercise of American quanto options," The North American Journal of Economics and Finance, Elsevier, vol. 62(C).
    8. Michał Wielechowski & Katarzyna Czech, 2021. "Companies’ Stock Market Performance in the Time of COVID-19: Alternative Energy vs. Main Stock Market Sectors," Energies, MDPI, vol. 15(1), pages 1-26, December.

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    More about this item

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • E10 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - General
    • E20 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
    • E27 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation: Models and Applications
    • G00 - Financial Economics - - General - - - General
    • G01 - Financial Economics - - General - - - Financial Crises
    • G1 - Financial Economics - - General Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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