Option Prices in a Model with Stochastic Disaster Risk

Sang Byung Seo, Jessica A. Wachter

NBER Working Paper No. 19611
Issued in November 2013
NBER Program(s):   AP

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 slope of implied volatilities, as well as the average implied volatility curve.

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This paper was revised on July 3, 2014

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w19611

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