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Option prices in a model with stochastic disaster risk ∗ Sang Byung Seo
, 2013
"... In a challenge to models that link the equity premium to rare disasters, Backus, Chernov, and Martin (2011) show that data on options imply negative events that are far smaller than these models suggest. We show that this result depends critically on the assumption that the probability of the rare e ..."
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Cited by 7 (2 self)
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In a challenge to models that link the equity premium to rare disasters, Backus, Chernov, and Martin (2011) show that data on options imply negative events that are far smaller than these models suggest. We show that this result depends critically on the assumption that the probability of the rare event is constant. That is, a model with stochastic jumps in consumption can simultaneously explain options data and the equity premium. Indeed, such a model delivers an excellent fit to implied volatilities, despite being calibrated to match the equity premium and equity volatility alone.
Disaster Risk and its Implications for Asset Pricing
 NBER Working Papers 20926, National Bureau of Economic Research, Inc
, 2015
"... After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premi ..."
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Cited by 1 (0 self)
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After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.
Crash Risk in Currency Returns ∗ Mikhail Chernov UCLA and CEPR †
, 2010
"... We quantify crash risk in currency returns. To accomplish this task, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model include ..."
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We quantify crash risk in currency returns. To accomplish this task, we develop and estimate an empirical model of exchange rate dynamics using daily data for four currencies relative to the US dollar: the Australian dollar, the British pound, the Swiss franc, and the Japanese yen. The model includes (i) normal shocks with stochastic variance, (ii) jumps up and down in the exchange rate, and (iii) jumps in the variance. We identify these components using data on exchange rates and atthemoney implied variances. We find that crash risk is timevarying. The probability of an upward (downward) jump in the exchange rate, associated with depreciation (appreciation) of the US dollar, is increasing in the domestic (foreign) interest rate. The probability of a jump in variance is increasing in the variance but is not related to interest rates. Many of the jumps in exchange rates are associated with macroeconomic and political news, but jumps in variance are not. On average, jumps account for 25 % of total currency risk (and can be as high as 40%), as measured by the entropy of exchange rate changes, over horizons of one to three months. The dollar carry index, which is based on 21 exchange rates, retains these features. A simple calibration analysis using optionimplied smiles suggests that jump risk is priced.
is given to the source. Disaster Risk and its Implications for Asset Pricing
, 2015
"... herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies ..."
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herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.
Essays In Asset Pricing And Tail Risk
, 2015
"... The first chapter "Option Prices in a Model with Stochastic Disaster Risk, " coauthored with Jessica Wachter, studies the consistency between the rare disaster mechanism and options data. In contrast to past work based on an iid setup, we find that a model with stochastic disaster risk ca ..."
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The first chapter "Option Prices in a Model with Stochastic Disaster Risk, " coauthored with Jessica Wachter, studies the consistency between the rare disaster mechanism and options data. In contrast to past work based on an iid setup, we find that a model with stochastic disaster risk can explain average implied volatilities well, despite being calibrated to consumption and aggregate market data alone. Furthermore, we extend the stochastic disaster risk model to a twofactor model and show that it can match variation in the level and slope of implied volatilities, as well as the average implied volatility curves. The second chapter "Do Rare Events Explain CDX Tranche Spreads?, " also coauthored with Jessica Wachter, investigates the rare disaster mechanism based on the data on the CDX index and its tranches. Senior tranches are essentially deep outofthemoney options because they do not incur any losses until a large number of investmentgrade firms default. Using the twofactor stochastic disaster model, we jointly explain the spreads on each CDX tranche, as well as prices on put options and the aggregate market. This paper demonstrates the importance of beliefs about rare disasters and shows a basic consistency in these beliefs across different asset markets. In the third chapter, "Correlated Defaults and Economic Catastrophes: Linking the CDS Market and Asset