Uncertainty, Time-Varying Fear, and Asset Prices

This paper studies the equilibrium asset pricing implications of time-varying (Knightian) uncertainty regarding economic fundamentals. The paper argues that uncertainty and its variation are important for jointly explaining the equity premium, risk-free rate, and the large variance premium embedded in the “high” price of options. A calibration of the model is able to simultaneously match salient moments of consumption and dividends, the equity premium, risk-free rate, the variance premium and impliedvolatility skew, and the documented predictive power of the variance premium for stock returns. The calibration quantitatively demonstrates that uncertainty is strongly reflected in option prices, that fluctuations in the VIX and implied-volatility curve contain an important uncertainty component, and that this component can account for the variance-premium’s predictive power. The paper contributes to the ambiguity aversion/robustness literature by solving in closed form for asset prices when the representative agent is ambiguous about both jump and diffusive shocks and has recursive preferences. Preliminary and Incomplete ∗I thank my committee, Amir Yaron (Chair), Rob Stambaugh, and Stavros Panageas. I also thank Andy Abel, Philipp Illeditsch, Jakub Jurek, Freda Song, Nick Souleles, and Paul Zurek for helpful comments. I thank Nim Drexler and a contact at Citigroup for the over-the-counter options data. †The Wharton School, University of Pennsylvania, [email protected].