Uncertainty, Time‐Varying Fear, and Asset Prices

  • Author(s): ITAMAR DRECHSLER
  • Published: Sep 10, 2013
  • Pages: 1843-1889
  • DOI: 10.1111/jofi.12068

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 reasonable model uncertainty explain option prices and the variance premium. Time variation in uncertainty generates variance premium fluctuations, helping explain their power to predict stock returns.

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