The Fear of Rare Economic Disasters Reflected in Option Prices

Abstract

The paper studies the asset pricing implications of economic disaster risk in the financial markets. We consider rare events as jumps in aggregate consumption with time-varying intensity. We use a general equilibrium framework with recursive preferences and allow the elasticity of intertemporal substitution (EIS) to deviate from one. The prices are obtained imposing an affine structure on the state variables. In order to assess the ex-ante risk perceived by investors we compute put option prices. The empirical estimation is based on S&P500 options to imply the time series of jump intensity and the utility parameters. We find that volatility smiles flatten out with maturity, which captures the long-term influence of disasters. We explore the effect of an EIS different from one and show that while an EIS > 1 fits better option data, an EIS