Tractable Rare Disaster Probability and Options-Pricing
Abstract: We derive an option-pricing formula from recursive preference and estimate rare disaster probability. The new options-pricing formula applies to far-out-of-the money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the economy has a representative agent with Epstein-Zin utility. The formula conforms with options data on the S&P 500 index from 1983-2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the 2008-2009 financial crisis, and forecasts equity index returns and growth vulnerabilities in the economy.
File(s): File format is application/pdf https://www.federalreserve.gov/econres/feds/files/2019073pap.pdf
Part of Series: Finance and Economics Discussion Series
Publication Date: 2019-09-27
Pages: 55 pages