Working Paper: NBER ID: w15240
Authors: David Backus; Mikhail Chernov; Ian Martin
Abstract: 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.
Keywords: Equity Index Options; Extreme Events; Asset Returns; High-order Cumulants
JEL Codes: E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| extreme events (disasters) (H84) | asset returns (G19) |
| high-order cumulants from equity index options (C69) | impact of extreme events on asset returns (G17) |
| presence of disasters (H84) | entropy of the pricing kernel (G19) |
| entropy of the pricing kernel (G19) | capacity of representative agent models to account for observed asset returns (C59) |
| market prices of options (G13) | premium for extreme negative outcomes (G22) |
| option prices (G13) | contributions from disasters (H84) |
| distribution of returns inferred from option prices (D39) | market perceptions of risk (D81) |