DP7416 Disasters implied by equity index options

Author(s): David Backus, Mikhail Chernov, Ian Martin
Publication Date: August 2009
Keyword(s): cumulants, entropy, equity premium, implied volatility, pricing kernel, risk-neutral probabilities
JEL(s): E44, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7416

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.