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Option Prices in a Model with Stochastic Disaster Risk

Author

Listed:
  • Sang Byung Seo

    (University of Houston, Houston, Texas 77204)

  • Jessica A. Wachter

    (University of Pennsylvania, Philadelphia, Pennsylvania 19104; and National Bureau of Economic Research, Cambridge, Massachusetts 02138)

Abstract

Contrary to well-known asset pricing models, volatilities implied by equity index options exceed realized stock market volatility and exhibit a pattern known as the volatility skew. We explain both facts using a model that can also account for the mean and volatility of equity returns. Our model assumes a small risk of economic disaster that is calibrated based on international data on large consumption declines. We allow the disaster probability to be stochastic, which turns out to be crucial to the model’s ability both to match equity volatility and to reconcile option prices with macroeconomic data on disasters.

Suggested Citation

  • Sang Byung Seo & Jessica A. Wachter, 2019. "Option Prices in a Model with Stochastic Disaster Risk," Management Science, INFORMS, vol. 65(8), pages 3449-3469, August.
    • Handle: RePEc:inm:ormnsc:v:65:y:2019:i:8:p:3449-3469
    DOI: 10.1287/mnsc.2017.2978
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    References listed on IDEAS

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