Uncertainty, Time-Varying Fear, and Asset Prices

Abstract

I construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk-free rate. A representative investor makes consumption and portfolio choice decisions that are robust to his uncertainty about the true economic model. He pays a large premium for index options because they hedge important model misspecification concerns, particularly concerning jump shocks to cash flow growth and volatility. A calibration shows that empirically-consistent fundamentals and a reasonable level of model uncertainty explain option prices and the variance premium. Time variation in investor uncertainty generates variance premium fluctuations and helps explain their power to predict stock returns.

Keywords: time-varying Knightian uncertainty, jump shocks, index options, variance premium, long-run risk

JEL Classification: G12, G13