ARE JUMPS IN STOCK RETURNS DIVERSIFIABLE - EVIDENCE AND IMPLICATIONS FOR OPTION PRICING

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