Essays In Asset Pricing And Tail Risk

The first chapter "Option Prices in a Model with Stochastic Disaster Risk, " co-authored with Jessica Wachter, studies the consistency between the rare disaster mechanism and options data. In contrast to past work based on an iid setup, we find that a model with stochastic disaster risk can explain average implied volatilities well, despite being calibrated to consumption and aggregate market data alone. Furthermore, we extend the stochastic disaster risk model to a two-factor model and show that it can match variation in the level and slope of implied volatilities, as well as the average implied volatility curves. The second chapter "Do Rare Events Explain CDX Tranche Spreads?, " also co-authored with Jessica Wachter, investigates the rare disaster mechanism based on the data on the CDX index and its tranches. Senior tranches are essentially deep out-of-the-money options because they do not incur any losses until a large number of investment-grade firms default. Using the two-factor stochastic disaster model, we jointly explain the spreads on each CDX tranche, as well as prices on put options and the aggregate market. This paper demonstrates the importance of beliefs about rare disasters and shows a basic consistency in these beliefs across different asset markets. In the third chapter, "Correlated Defaults and Economic Catastrophes: Linking the CDS Market and Asse