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Tails, Fears and Risk Premia

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Author Info
Tim Bollerslev () (Department of Economics, Duke University, Durham and CREATES)
Viktor Todorov () (Department of Finance, Kellogg School of Management, Northwestern University)

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Abstract

We show that the compensation for rare events accounts for a large fraction of the equity and variance risk premia in the S&P 500 market index. The probability of rare events vary significantly over time, increasing in periods of high market volatility, but the risk premium for tail events cannot solely be explained by the level of the volatil- ity. Our empirical investigations are essentially model-free. We estimate the expected values of the tails under the statistical probability measure from "medium" size jumps in high-frequency intraday prices and an extreme value theory approximation for the corresponding jump tail density. Our estimates for the risk-neutral expectations are based on short maturity out-of-the money options and new model-free option implied variation measures explicitly designed to separate the tail probabilities. At a general level, our results suggest that any satisfactory equilibrium based asset pricing model must be able to generate large and time-varying compensations for fears of disasters.

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Publisher Info
Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2009-26.

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Length: 44
Date of creation: 11 Jun 2009
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Handle: RePEc:aah:create:2009-26

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Related research
Keywords: rare events; jumps; high-frequency data; options; fears; extreme value theory; equity risk premium; variance risk premium;

Find related papers by JEL classification:
C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Estimation
C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Semiparametric and Nonparametric Methods
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
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  1. Emmanuel Farhi & Samuel Paul Fraiberger & Xavier Gabaix & Romain Ranciere & Adrien Verdelhan, 2009. "Crash Risk in Currency Markets," NBER Working Papers 15062, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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