NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

NBER Publications by Sang Byung Seo

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Working Papers and Chapters and Reporter Articles

October 2016Do Rare Events Explain CDX Tranche Spreads?
with Jessica A. Wachter: w22723
We investigate whether a model with a time-varying probability of economic disaster can explain the pricing of collateralized debt obligations, both prior to and during the 2008-2009 financial crisis. Namely, we examine the pricing of tranches on the CDX, an index of credit default swaps on large investment-grade firms. CDX senior tranches are essentially deep out-of-the money put options because they do not incur losses until a large fraction of previously stable firms default. As such, these products clearly reflect the market’s assessment of rare-event risk. We find that the model can simultaneously explain prices on CDX senior tranches and on equity index options at parameter values that are consistent with the equity premium and with aggregate stock market volatility. Our results demo...
November 2013Option Prices in a Model with Stochastic Disaster Risk
with Jessica A. Wachter: w19611
Contrary to the Black-Scholes model, volatilities implied by index option prices depend on the exercise price of the option and are often higher than realized volatilities. We explain both facts in the context of a model that can also explain the mean and volatility of equity returns. Our model assumes a small risk of a rare disaster that is calibrated based on the international data on large consumption declines. We allow the risk of this rare disaster to be stochastic, which turns out to be crucial to the model's ability to explain both equity volatility and option prices. We explore different specifications for the stochastic rare disaster probability and show that the data favor a multifrequency process. Finally, we show that the model can simultaneously fit the time series of option p...

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