General equilibrium pricing of options with habit formation and event risks

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

32 Scopus Citations
View graph of relations



Original languageEnglish
Pages (from-to)400-426
Journal / PublicationJournal of Financial Economics
Issue number2
Publication statusPublished - Feb 2011
Externally publishedYes


This paper proposes a general equilibrium model that explains the pricing of the S&P 500 index options. The central ingredients are a peso component in the consumption growth rate and the time-varying risk aversion induced by habit formation which amplifies consumption shocks. The amplifying effect generates the excess volatility and a large jump-risk premium which combine to produce a pronounced volatility smirk for index options. The time-varying volatility and jump-risk premiums explain the observed state-dependent smirk patterns. Besides volatility smirks, the model has a variety of other implications which are broadly consistent with the aggregate stock and option market data. © 2010 Elsevier B.V.

Research Area(s)

  • Economic disasters, Habit formation, Jump-risk premium, Volatility smirk