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Hedging jump risk, expected returns and risk premia in jump-diffusion economies

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  • Oliver X. Li
  • Weiping Li

Abstract

This article presents a pure exchange economy that extends Rubinstein [ Bell J. Econ. Manage. Sci. , 1976, 7 , 407-425] to show how the jump-diffusion option pricing model of Black and Scholes [ J. Political Econ. , 1973, 81 , 637-654] and Merton [ J. Financ. Econ. , 1976, 4 , 125-144] evolves in gamma jumping economies. From empirical analysis and theoretical study, both the aggregate consumption and the stock price are unknown in determining jumping times. By using the pricing kernel, we determine both the aggregate consumption jump time and the stock price jump time from the equilibrium interest rate and CCAPM (Consumption Capital Asset Pricing Model). Our general jump-diffusion option pricing model gives an explicit formula for how the jump process and the jump times alter the pricing. This innovation with predictable jump times enhances our analysis of the expected stock return in equilibrium and of hedging jump risks for jump-diffusion economies.

Suggested Citation

  • Oliver X. Li & Weiping Li, 2015. "Hedging jump risk, expected returns and risk premia in jump-diffusion economies," Quantitative Finance, Taylor & Francis Journals, vol. 15(5), pages 873-888, May.
    • Handle: RePEc:taf:quantf:v:15:y:2015:i:5:p:873-888
    DOI: 10.1080/14697688.2014.946439
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    Cited by:

    1. Bin Xie & Weiping Li & Nan Liang, 2021. "Pricing S&P 500 Index Options with L\'evy Jumps," Papers 2111.10033, arXiv.org, revised Nov 2021.
    2. Li, Yan & Liang, Chao & Huynh, Toan L.D. & He, Qiubei, 2022. "Price reversal and heterogeneous belief," International Review of Economics & Finance, Elsevier, vol. 82(C), pages 104-119.

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