Explaining asset pricing puzzles associated with the 1987 market crash |
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Authors: | Luca Benzoni Pierre Collin-Dufresne Robert S Goldstein |
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Institution: | a Federal Reserve Bank of Chicago, 230 S. LaSalle Street, Chicago, IL 60604, United States b Columbia Business School, 3022 Broadway, Uris Hall 404, New York, NY 10027, United States c Carlson School of Management, University of Minnesota, 321 19th Ave S., Minneapolis, MN 55455, United States d NBER, United States |
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Abstract: | The 1987 market crash was associated with a dramatic and permanent steepening of the implied volatility curve for equity index options, despite minimal changes in aggregate consumption. We explain these events within a general equilibrium framework in which expected endowment growth and economic uncertainty are subject to rare jumps. The arrival of a jump triggers the updating of agents' beliefs about the likelihood of future jumps, which produces a market crash and a permanent shift in option prices. Consumption and dividends remain smooth, and the model is consistent with salient features of individual stock options, equity returns, and interest rates. |
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Keywords: | Volatility smile Volatility smirk Implied volatility Option pricing Portfolio insurance |
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