Explaining Asset Pricing Puzzles Associated with the 1987 Market Crash
49 Pages Posted: 27 Jan 2010 Last revised: 1 Jul 2011
Date Written: June 7, 2010
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.
Keywords: Volatility Smile, Volatility Smirk, Implied Volatility, Option Pricing, Portfolio Insurance, Market Risk
JEL Classification: G12, G13, E10
Suggested Citation: Suggested Citation