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Are Jumps in Stock Returns Diversifiable? Evidence and Implications for Option Pricing

Published online by Cambridge University Press:  06 April 2009

Myung-Jig Kim ,
Young-Ho Oh  and
Robert Brooks
Myung-Jig Kim
Affiliation:
Department of Economics, Finance, and Legal Studies, College of Commerce
Young-Ho Oh
Affiliation:
Department of Economics, Finance, and Legal Studies, College of Commerce
Robert Brooks
Affiliation:
Business Administration, University of Alabama, Tuscaloosa, AL 35487.
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Abstract

This paper studies the diversifiability of jumps in stock returns. It presents a multivariate time-series model of the stochastic process for an index and its component stocks that explicitly admits discrete common jumps. Maximum likelihood estimation for such a model is developed and applied to the daily Major Market Index and its component stocks for the period 1985 through 1990. The paper finds that Poisson-distributed jumps observed from both the index and its component stocks constitute nondiversifiable risk, implying that the standard assumption in option pricing that these jumps are not priced may be invalid.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 29 , Issue 4 , December 1994 , pp. 609 - 631
Copyright
Copyright © School of Business Administration, University of Washington 1994

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