Working Paper: NBER ID: w21888
Authors: Robert J. Barro; Gordon Y. Liao
Abstract: A new options-pricing formula applies to far-out-of-the money put options on the overall stock market when disaster risk is the dominant force, the size distribution of disasters follows a power law, and the economy has a representative agent with Epstein-Zin utility. In the applicable region, the elasticity of the put-options price with respect to maturity is close to one. The elasticity with respect to exercise price is greater than one, roughly constant, and depends on the difference between the power-law tail parameter and the coefficient of relative risk aversion, γ. The options-pricing formula conforms with data from 1983 to 2015 on far-out-of-the-money put options on the U.S. S&P 500 and analogous indices for other countries. The analysis uses two types of data—indicative prices on OTC contracts offered by a large financial firm and market data provided by OptionMetrics, Bloomberg, and Berkeley Options Data Base. The options-pricing formula involves a multiplicative term that is proportional to the disaster probability, p. If γ and the size distribution of disasters are fixed, time variations in p can be inferred from time fixed effects. The estimated disaster probability peaks particularly during the recent financial crisis of 2008-09 and the stock-market crash of October 1987.
Keywords: No keywords provided
JEL Codes: E44; G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| disaster risk (H84) | pricing of far-out-of-the-money put options (G13) |
| maturity of options (G13) | pricing of far-out-of-the-money put options (G13) |
| exercise price (G13) | pricing of far-out-of-the-money put options (G13) |
| disaster probabilities (H84) | option prices (G13) |
| disaster risk (H84) | elasticity of put options' prices with respect to maturity (G13) |
| disaster risk (H84) | elasticity concerning exercise price (G13) |