NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

NBER Working Papers by Sang Byung Seo

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Working Papers

November 2013Option Prices in a Model with Stochastic Disaster Risk
with Jessica A. Wachter: w19611
Large rare shocks to aggregate consumption, namely, disasters, have been proposed as an explanation for the equity premium. However, recent work suggests that the consumption distribution required by this mechanism is inconsistent with the average implied volatility curve derived from option prices. We show that this apparent inconsistency can be resolved in a model with stochastic disaster risk. That is, we show that a model with a stochastic probability of disaster can explain average implied volatilities, despite being calibrated to consumption and aggregate market data alone. We also extend the stochastic disaster risk model to one that allows for variation in the risk of disaster at different time scales. We show that this extension allows the model to match variation in the level and...

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