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Explaining asset pricing puzzles associated with the 1987 market crash

  • Luca Benzoni
  • Pierre Collin-Dufresne
  • Robert S. Goldstein

The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features of individual stock options, equity returns, and interest rates.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-2010-10.

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Date of creation: 2010
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Handle: RePEc:fip:fedhwp:wp-2010-10
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