Published in:MIT Sloan Working Paper ; No. 4370-02 AFA 2003 Washington, DC Meetings
Extent:
1 Online-Ressource (22 p)
Language:
Not determined
DOI:
10.2139/ssrn.313205
Identifier:
Origination:
Footnote:
Nach Informationen von SSRN wurde die ursprüngliche Fassung des Dokuments May 21, 2002 erstellt
Description:
In this paper, we study the asset pricing implication of imprecise knowledge about rare events. Modeling rare events as jumps in the aggregate endowment, we explicitly solve the equilibrium asset prices in a pure-exchange economy with a representative agent who is averse not only to risk but also to model uncertainty with respect to rare events. Our results show that there are three components in the equity premium: the diffusive-risk premium, the jump-risk premium, and the quot;rare event premium.quot; While the first two premia are generated by risk aversion, the last one is driven exclusively by uncertainty aversion. To disentangle the quot;rare event premiumquot; from the standard risk-based premia, we examine the equilibrium prices of options with varying degree of moneyness. We consider models with different levels of uncertainty aversion - including the one with zero uncertainty aversion, and calibrate all models to the same level of equity premium. Although observationally equivalent with respect to the equity market, these models provide distinctly different predictions on the option market. Without incorporating uncertainty aversion, the standard model cannot explain the extent of the premia implicit in options, particularly the prevalent quot;smirkquot; patterns documented in the index options market. In contrast, the models incorporating uncertainty aversion can generate significant premia for at-the-money option prices, as well as pronounced quot;smirkquot; patterns for options with different degrees of moneyness