EQUILIBRIUM ASSET AND OPTION PRICING UNDER JUMP DIFFUSION

Abstract

This paper develops an equilibrium asset and option pricing model in a production economy under jump diffusion. The model provides analytical formulas for an equity premium and a more general pricing kernel that links the physical and risk‐neutral densities. The model explains the two empirical phenomena of the negative variance risk premium and implied volatility smirk if market crashes are expected. Model estimation with the S&P 500 index from 1985 to 2005 shows that jump size is indeed negative and the risk aversion coefficient has a reasonable value when taking the jump into account.

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