Jump Propagation and Dynamic Derivative Investment

We study the propagation of stock price jumps that the strike of one jump substantially raises the probability for more to follow, and examine its implications on investors optimal derivative strategies. Model ¬ estimation identities severe jump propagation which proves essential to fitting the joint data of stock and options. On average, propagation contributes to 40% of the total jump risks, and it is as effective as jump intensity in raising option smirk premium. Without volatility risks, investors take aggressive derivative position to exploit the high premium attributed to jump propagation. The premium effect, however, is more than offset in the general case where derivative securities interact with each other as vehicles to access both the jump and the volatility risks. Facing infectious jumps, the investors benefits substantially by derivatives trading.