Discussion Paper Details

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Title: Disasters implied by equity index options

Author(s): David Backus, Mikhail Chernov and Ian Martin

Publication Date: August 2009

Keyword(s): cumulants, entropy, equity premium, implied volatility, pricing kernel and risk-neutral probabilities

Programme Area(s): Financial Economics

Abstract: We use prices of equity index options to quantify the impact of extreme events on asset returns. We define extreme events as departures from normality of the log of the pricing kernel and summarize their impact with high-order cumulants: skewness, kurtosis, and so on. We show that high-order cumulants are quantitatively important in both representative-agent models with disasters and in a statistical pricing model estimated from equity index options. Option prices thus provide independent confirmation of the impact of extreme events on asset returns, but they imply a more modest distribution of them.

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Bibliographic Reference

Backus, D, Chernov, M and Martin, I. 2009. 'Disasters implied by equity index options'. London, Centre for Economic Policy Research.