General Equilibrium Option Pricing under Counter-Cyclical Growth and Long-Run Risk

Abstract

Put option prices are counter-cyclical. We build a general equilibrium model based on Duffie-Epstein preferences and Ak production function that delivers a model of put option prices that captures both time-series and cross-sectional properties of relative put option prices. When estimated with US aggregate consumption data and S&P 500 index options using Bayesian MCMC, we confirm our theory that agents have elasticity of intertemporal substitution greater than 1 which confirms the substitution effect, and put option prices reveal the underlying counter-cyclical economic state. The underlying economic dynamics, when combined with long-run risk nature of Duffie-Epstein preferences, can match the time-series and cross-section of US option prices with our theory.