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This book mainly addresses the general equilibrium asset pricing method in two aspects: option pricing and variance risk premium. First, volatility smile and smirk is the famous puzzle in option pricing. Different from no arbitrage method, this book applies the general equilibrium approach in explaining the puzzle. In the presence of jump, investors impose more weights on the jump risk than the volatility risk, and as a result, investors require more jump risk premium which generates a pronounced volatility smirk. Second, based on the general equilibrium framework, this book proposes variance risk premium and empirically tests its predictive power for international stock market returns.
This paper derives a general equilibrium option-pricing model for a European call assuming that the economy is exogenously driven by a dividend process following Hamilton's (1989) Markov regime switching model. The derived formula is used to investigate if the European call option prices are consistently priced with the stock market prices. This is done by obtaining the implied risk aversion preferences, based on traded option prices data.
Written by one of the key pioneers in the field, this book offers an accessible introduction to general equilibrium theory. Written for undergraduates taking courses in economic theory and modelling who have limited mathematical proficiency, the book fills a gap between forbidding technical expositions and the less rigorous elementary ones.
Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments.
In this paper, we derive an equilibrium in which some investors buy call/put options on an asset while others sell them. Also, some investors supply and others demand forward contracts. Since investors are assumed to have similar risk-averse preferences, the demand for these contracts is not explained by differences in the shape of the utility functions. Rather, it is the degree to which agents face other, non-hedgeable, background risks that determines their hedging behavior in the model. For example, a privately- held firm exposed to foreign exchange risk may have profits which also depend on non-hedgeable risks in specific product markets. Our model suggests that the degree to which the firm will hedge the foreign exchange risk depends on the level of firm-specific risk to which it is subject. We show that investors with low or no background risk sell portfolio insurance, i.e., they sell options on the market portfolio, whereas investors with high background risk buy those options. A general increase in background risk in the economy reduces the forward price of the market portfolio. Also, the price of put options rises and the price of call options falls. However, in an economy with given background risk, all options will be overpriced if the option pricing model ignores the background risk.
This book presents an original exposition of general equilibrium theory for advanced undergraduate and graduate-level students of economics. It contains detailed discussions of economic efficiency, competitive equilibrium, the first and second welfare theorems, the Kuhn-Tucker approach to general equilibrium, the Arrow-Debreu model, and rational expectations equilibrium and the permanent income hypothesis. Truman Bewley also treats optimal growth and overlapping generations models as special cases of the general equilibrium model. He uses the model and the first and second welfare theorems to explain the main ideas of insurance, capital theory, growth theory, and social security. It enables him to present a unified approach to portions of macro- as well as microeconomic theory. The book contains problems sets for most chapters.
This paper develops a closed form risk-neutral valuation model for pricing European style options when the underlying has a mixture of transformed-normal distributions. Specifically, we introduce the mixture of g distributions, which contains the mixture of normal and lognormal distributions as a special case. The risk neutral valuation relation is developed following Rubinstein (1976), Brennan (1979) and Camara (2003). Our model encompasses several well known models, and is particularly useful for pricing derivatives written on illiquid assets, and derivatives that are themselves illiquid.