Job Market Paper
Other Working Papers
Option Prices in a Model with Stochastic Disaster Risk (with Jessica Wachter)
Abstract: Large rare shocks to aggregate consumption, namely, disasters, have been proposed as an explanation for the equity premium. However, recent work suggests that the consumption distribution required by this mechanism is inconsistent with the average implied volatility curve derived from option prices. We show that this apparent inconsistency can be resolved in a model with stochastic disaster risk. That is, we show that a model with a stochastic probability of disaster can explain average implied volatilities, despite being calibrated to consumption and aggregate market data alone. We also extend the stochastic disaster risk model to one that allows for variation in the risk of disaster at different time scales. We show that this extension allows the model to match variation in the level and slope of implied volatilities, as well as the average implied volatility curve.
Do Rare Events Explain CDX Tranche Spreads? (with Jessica Wachter)
Abstract: The CDX is an index of credit default swaps on major U.S. Corporations. In the 2005--2009 period, contracts on the CDX as a whole and on tranches of the CDX were actively traded. Senior tranches are essentially deep out-of-the-money options because they do not incur any losses until a large number of investment-grade firms default. Because of the liquidity of these contracts, their spreads provide a unique window into how the market assesses the risk of a rare disaster. We propose a model to jointly explain the spreads on each CDX tranche, as well as prices on put options and the aggregate market. Our results demonstrate the importance of beliefs about rare events, even in periods of relatively high valuation. Moreover, our results show a basic consistency in these beliefs across different asset classes.