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|
|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.