Can standard preferences explain the prices of out-of-the-money S&P 500 put options?

The 1987 stock market crash occurred with minimal impact on observable economic variables (e.g., consumption), yet dramatically and permanently changed the shape of the implied volatility curve for equity index options. Here, we propose a general equilibrium model that captures many salient features of the U.S. equity and options markets before, during, and after the crash. The representative agent is endowed with Epstein-Zin preferences and the aggregate dividend and consumption processes are driven by a persistent stochastic growth variable that can jump. In reaction to a market crash, the agent updates her beliefs about the distribution of the jump component. We identify a realistic calibration of the model that matches the prices of shortmaturity at-the-money and deep out-of-the-money S&P 500 put options, as well as the prices of individual stock options. Further, the model generates a steep shift in the implied volatility ‘smirk’ for S&P 500 options after the 1987 crash. This ‘regime shift’ occurs in spite of a minimal impact on observable macroeconomic fundamentals. Finally, the model’s implications are consistent with the empirical properties of dividends, the equity premium, as well as the level and standard deviation of the risk-free rate. Overall, our findings show that it is possible to reconcile the stylized properties of the equity and option markets in the framework of rational expectations, consistent with the notion that these two markets are integrated.Money ; Macroeconomics ; Pricing

Can Standard Preferences Explain the Prices of out of the Money S&P 500 Put Options

Prior to the stock market crash of 1987, Black-Scholes implied volatilities of S&P 500 index options were relatively constant across moneyness. Since the crash, however, deep out-of-the-money S&P 500 put options have become %u2018expensive%u2019 relative to the Black-Scholes benchmark. Many researchers (e.g., Liu, Pan and Wang (2005)) have argued that such prices cannot be justified in a general equilibrium setting if the representative agent has %u2018standard preferences%u2019 and the endowment is an i.i.d. process. Below, however, we use the insight of Bansal and Yaron (2004) to demonstrate that the %u2018volatility smirk%u2019 can be rationalized if the agent is endowed with Epstein-Zin preferences and if the aggregate dividend and consumption processes are driven by a persistent stochastic growth variable that can jump. We identify a realistic calibration of the model that simultaneously matches the empirical properties of dividends, the equity premium, the prices of both at-the-money and deep out-of-the-money puts, and the level of the risk-free rate. A more challenging question (that to our knowledge has not been previously investigated) is whether one can explain within a standard preference framework the stark regime change in the volatility smirk that has maintained since the 1987 market crash. To this end, we extend the model to a Bayesian setting in which the agent updates her beliefs about the average jump size in the event of a jump. Note that such beliefs only update at crash dates, and hence can explain why the volatility smirk has not diminished over the last eighteen years. We find that the model can capture the shape of the implied volatility curve both pre- and post-crash while maintaining reasonable estimates for expected returns, price-dividend ratios, and risk-free rates.

Portfolio choice over the life-cycle when the stock and labor markets are cointegrated

We study portfolio choice when labor income and dividends are cointegrated. Economically plausible calibrations suggest young investors should take substantial short positions in the stock market. Because of cointegration the young agent's human capital effectively becomes.Portfolio management ; Stock market ; Labor market

Portfolio Choice over the Life-Cycle in the Presence of 'Trickle Down' Labor Income

Empirical evidence shows that changes in aggregate labor income and stock market returns exhibit only weak correlation at short horizons. As we document below, however, this correlation increases substantially at longer horizons, which provides at least suggestive evidence that stock returns and labor income are cointegrated. In this paper, we investigate the implications of such a cointegrated relation for life-cycle optimal portfolio and consumption decisions of an agent whose non-tradable labor income faces permanent and temporary idiosyncratic shocks. We find that, under economically plausible calibrations, the optimal portfolio choice for the young investor is to take a substantial {\em short} position in the risky portfolio, in spite of the large risk premium associated with it. Intuitively, this occurs because the cointegration effect makes the present value of future labor income flows `stock-like' for the young agent. However, for older agents who have shorter times-to-retirement, the cointegration effect does not have sufficient time to act, and the remaining human capital becomes more `bond-like.' Together, these effects create a hump-shaped optimal portfolio decision for the agent over the life cycle, consistent with empirical observation.

Co-periodic stability of periodic waves in some Hamiltonian PDEs

International audienceThe stability theory of periodic traveling waves is much less advanced than for solitary waves, which were first studied by Boussinesq and have received a lot of attention in the last decades. In particular, despite recent breakthroughs regarding periodic waves in reaction-diffusion equations and viscous systems of conservation laws [Johnson–Noble–Rodrigues–Zumbrun, Invent math (2014)], the stability of periodic traveling wave solutions to dispersive PDEs with respect to 'arbitrary' perturbations is still widely open in the absence of a dissipation mechanism. The focus is put here on co-periodic stability of periodic waves, that is, stability with respect to perturbations of the same period as the wave, for KdV-like systems of one-dimensional Hamiltonian PDEs. Fairly general nonlinearities are allowed in these systems, so as to include various models of mathematical physics, and this precludes complete integrability techniques. Stability criteria are derived and investigated first in a general abstract framework, and then applied to three basic examples that are very closely related, and ubiquitous in mathematical physics, namely, a quasilinear version of the generalized Korteweg–de Vries equation (qKdV), and the Euler–Korteweg system in both Eulerian coordinates (EKE) and in mass Lagrangian coordinates (EKL). Those criteria consist of a necessary condition for spectral stability , and of a sufficient condition for orbital stability. Both are expressed in terms of a single function, the abbreviated action integral along the orbits of waves in the phase plane, which is the counterpart of the solitary waves moment of instability introduced by Boussinesq. However, the resulting criteria are more complicated for periodic waves because they have more degrees of freedom than solitary waves, so that the action is a function of N + 2 variables for a system of N PDEs, while the moment of instability is a function of the wave speed only once the endstate of the 1 solitary wave is fixed. Regarding solitary waves, the celebrated Grillakis–Shatah– Strauss stability criteria amount to looking for the sign of the second derivative of the moment of instability with respect to the wave speed. For periodic waves, stability criteria involve all the second order, partial derivatives of the action. This had already been pointed out by various authors for some specific equations, in particular the generalized Korteweg–de Vries equation — which is special case of (qKdV) — but not from a general point of view, up to the authors' knowledge. The most striking results obtained here can be summarized as: an odd value for the difference between N and the negative signature of the Hessian of the action implies spectral instability, whereas a negative signature of the same Hessian being equal to N implies orbital stability. Furthermore, it is shown that, when applied to the Euler–Korteweg system, this approach yields several interesting connexions between (EKE), (EKL), and (qKdV). More precisely, (EKE) and (EKL) share the same abbreviated action integral, which is related to that of (qKdV) in a simple way. This basically proves simultaneous stability in both formulations (EKE) and (EKL) — as one may reasonably expect from the physical point view —, which is interesting to know when these models are used for different phenomena — e.g. shallow water waves or nonlinear optics. In addition, stability in (EKE) and (EKL) is found to be linked to stability in the scalar equation (qKdV). Since the relevant stability criteria are merely encoded by the negative signature of (N + 2) × (N + 2) matrices, they can at least be checked numerically. In practice, when N = 1 or 2, this can be done without even requiring an ODE solver. Various numerical experiments are presented, which clearly discriminate between stable cases and unstable cases for (qKdV), (EKE) and (EKL), thus confirming some known results for the generalized KdV equation and the Nonlinear Schrödinger equation, and pointing out some new results for more general (systems of) PDEs

Weak solutions to problems involving inviscid fluids

We consider an abstract functional-differential equation derived from the pressure-less Euler system with variable coefficients that includes several systems of partial differential equations arising in the fluid mechanics. Using the method of convex integration we show the existence of infinitely many weak solutions for prescribed initial data and kinetic energy

Does Judicial Philosophy Matter?: A Case Study

A leading theory in the study of judicial behavior is the attitudinal model. This theory maintains that a judge\u27s political ideology can be used to predict how a judge will decide certain cases; other factors, such as the judge\u27s judicial philosophy, tend to be unimportant. Under this theory, two judges with the same political ideology, but different judicial philosophies, should virtually always vote the same way in cases with pre­dicted ideological outcomes. This manuscript tests the attitudinal model by examin­ing opinions by two judges with very similar political ideologies but different judicial philosophies: Judge Michael Luttig and Judge Harvie Wilkinson III of the US. Court of Appeals for the Fourth Circuit. After defining the judges\u27 political ideologies and judicial philosophies, this study examines political cases in which one of these judges wrote the majority opinion and the other dissented. The result of the study is that when these judges came to different conclusions in these ideological cases, it is likely they did so on the basis of their judicial philosophies. In short, contra the attitudinal model, at least in some cases judi­cial philosophy does matter

Nonlinear surface waves on the plasma-vacuum interface

In this paper we study the propagation of weakly nonlinear surface waves on a plasma-vacuum interface. In the plasma region we consider the equations of incompressible magnetohydrodynamics, while in vacuum the magnetic and electric fields are governed by the Maxwell equations. A surface wave propagate along the plasma-vacuum interface, when it is linearly weakly stable. Following the approach of Ali and Hunter, we measure the amplitude of the surface wave by the normalized displacement of the interface in a reference frame moving with the linearized phase velocity of the wave, and obtain that it satisfies an asymptotic nonlocal, Hamiltonian evolution equation. We show the local-in-time existence of smooth solutions to the Cauchy problem for the amplitude equation in noncanonical variables, and we derive a blow up criterion.Comment: arXiv admin note: text overlap with arXiv:1305.5327 by other author

Penalty Methods for the Hyperbolic System Modelling the Wall-Plasma Interaction in a Tokamak

The penalization method is used to take account of obstacles in a tokamak, such as the limiter. We study a non linear hyperbolic system modelling the plasma transport in the area close to the wall. A penalization which cuts the transport term of the momentum is studied. We show numerically that this penalization creates a Dirac measure at the plasma-limiter interface which prevents us from defining the transport term in the usual sense. Hence, a new penalty method is proposed for this hyperbolic system and numerical tests reveal an optimal convergence rate without any spurious boundary layer.Comment: 8 pages; International Symposium FVCA6, Prague : Czech Republic (2011