Rare disaster probability and options pricing

We derive an options-pricing formula from recursive preferences and estimate rare disaster probability. The new options-pricing formula applies to far out-of-the-money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the econom...

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Bibliographic Details
Published inJournal of financial economics Vol. 139; no. 3; pp. 750 - 769
Main Authors Barro, Robert J., Liao, Gordon Y.
Format Journal Article
LanguageEnglish
Published Amsterdam Elsevier B.V 01.03.2021
Elsevier Sequoia S.A
Subjects
Disasters
Economic crisis
Economic growth
Federal Reserve banks
Money
Options (Finance)
Pricing
Probability
Put & call options
Risk assessment
Risk aversion
Securities markets
Securities prices
Stock markets
Studies
Utility functions
E20
E00
E10
G00
G01
G12
G1
G15
E27
G17
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Summary:We derive an options-pricing formula from recursive preferences and estimate rare disaster probability. The new options-pricing formula applies to far out-of-the-money put options on the stock market when disaster risk dominates, the size distribution of disasters follows a power law, and the economy has a representative agent with a constant-relative-risk-aversion utility function. The formula conforms with options data on the Standard & Poor's (S&P) 500 Index from 1983 to 2018 and for analogous indices for other countries. The disaster probability, inferred from monthly fixed effects, is highly correlated across countries, peaks during the Global Financial Crisis, and forecasts rates of economic growth.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2020.10.001