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An Equilibrium Guide to Designing Affine Pricing Models, Mathematical Finance forthcoming (2007)
| Citations: | 46 - 14 self |
BibTeX
@MISC{Eraker07anequilibrium,
author = {Bjørn Eraker and Ivan Shaliastovich and Tim Bollerslev and Xin Huang and George Tauchen},
title = {An Equilibrium Guide to Designing Affine Pricing Models, Mathematical Finance forthcoming},
year = {2007}
}
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Abstract
We examine equilibriummodels based on Epstein-Zin preferences in a frame-work where exogenous state variables which drive consumption and dividend dynamics follow affine jump diffusion processes. Equilibrium asset prices can be computed using a standard machinery of affine asset pricing theory by imposing parametric restrictions on market prices of risk, determined by preference and model parameters. We present a detailed example where large shocks (jumps) in consumption volatility translate into negative jumps in equilibrium prices of the assets. This endogenous ”leverage effect ” leads to significant premiums for out-of-the-money put options. Our model is thus able to produce an equi-librium ”volatility smirk ” which realistically mimics that observed for index options. KEY WORDS: Epstein-Zin preferences, affine asset pricing model, general equilibrium, option pricing ∗We thank two anonymous referees and the associate editor for valuable comments. We have also
Keyphrases
designing affine pricing model mathematical finance forthcoming equilibrium guide epstein-zin preference significant premium affine asset pricing model equilibrium asset price anonymous referee endogenous leverage effect consumption volatility valuable comment index option model parameter standard machinery associate editor negative jump affine jump diffusion dividend dynamic affine asset pricing theory market price out-of-the-money put option parametric restriction detailed example equi-librium volatility smirk large shock key word option pricing exogenous state variable equilibrium price general equilibrium
