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Disasters Implied by Equity Index Options
Author(s) -
BACKUS DAVID,
CHERNOV MIKHAIL,
MARTIN IAN
Publication year - 2011
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.2011.01697.x
Subject(s) - macro , equity (law) , economics , index (typography) , econometrics , valuation of options , consumption (sociology) , equity premium puzzle , distribution (mathematics) , financial economics , actuarial science , capital asset pricing model , mathematics , computer science , mathematical analysis , social science , sociology , world wide web , political science , law , programming language
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. 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 macroeconomic data.