Explaining asset pricing puzzles associated with the 1987 market crash
Abstract: The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features of individual stock options, equity returns, and interest rates.
File(s): File format is application/pdf http://www.chicagofed.org/digital_assets/publications/working_papers/2010/wp2010_10.pdf
Provider: Federal Reserve Bank of Chicago
Part of Series: Working Paper Series
Publication Date: 2010