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The Market for Crash Risk

38 citations0/0 files storedNational Bureau of Economic Research

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Stochastic processes and financial applications Financial Markets and Investment Strategies Financial Risk and Volatility Modeling

Abstract

This paper examines the equilibrium when negative stock market jumps (crashes) can occur, and investors have heterogeneous attitudes towards crash risk.The less crash-averse insure the more crash-averse through the options markets that dynamically complete the economy.The resulting equilibrium is compared with various option pricing anomalies reported in the literature: the tendency of stock index options to overpredict volatility and jump risk, the Jackwerth (2000) implicit pricing kernel puzzle, and the stochastic evolution of option prices.The specification of crash aversion is compatible with the static option pricing puzzles, while heterogeneity partially explains the dynamic puzzles.Heterogeneity also magnifies substantially the stock market impact of adverse news about fundamentals.

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References

1973An Intertemporal Capital Asset Pricing Model 1997The Econometrics of Financial Markets 1998The relation between implied and realized volatility 1999Consumption and Portfolio Decisions when Expected Returns are Time Varying 2000Recovering Risk Aversion from Option Prices and Realized Returns 2000Nonparametric risk management and implied risk aversion 1995Predicting Volatility in the Foreign Exchange Market 2002Empirical pricing kernels

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2004The Econometrics of Option Pricing 2011Pricing American interest rate options under the jump-extended constant-elasticity-of-variance short rate models 2003The Information in Option Volume for Stock Prices 2002Dynamic Derivative Strategies 2007Option prices, exchange market intervention, and the higher moment expectations channel: a user's guide

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