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Disasters implied by equity index options

Backus, David, Chernov, Mikhail and Martin, Ian (2011) Disasters implied by equity index options. The Journal of Finance, 66 (6). pp. 1969-2012. ISSN 0022-1082

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Abstract

We use equity index options to quantify the distribution of consumption growth disasters. The challenge lies in connecting the risk-neutral distribution of equity returns implied by options to the true distribution of consumption growth estimated from macroeconomic data. We attack the problem from three perspectives. First, we compare pricing kernels constructed from macro-finance and option-pricing models. Second, we compare option prices derived from a macro-finance model to those we observe. Third, we compare the distribution of consumption growth derived from option prices using a macro-finance model to estimates based on macroeconomic data. All three perspectives suggest that options imply smaller probabilities of extreme outcomes than have been estimated from international macroeconomic data. The third comparison yields a viable alternative calibration of the distribution of consumption growth that matches the equity premium, option prices, and the sample moments of US consumption growth.

Item Type: Article
Official URL: http://www.afajof.org/journal/
Additional Information: © 2011 The American Finance Association
Library of Congress subject classification: H Social Sciences > HB Economic Theory
H Social Sciences > HJ Public Finance
Journal of Economic Literature Classification System: E - Macroeconomics and Monetary Economics > E1 - General Aggregative Models
E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Employment, and Investment
Sets: Departments > Finance
Collections > Economists Online
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Date Deposited: 10 Nov 2011 10:02
URL: http://eprints.lse.ac.uk/39392/

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