Option Prices with Uncertain Fundamentals Theory and Evidence on the Dynamics of Implied Volatilities

In an incomplete information model, investors' uncertainty about the underlying drift rate of a rm's fundamentals a ects option prices through (i) endogenous and belief-dependent stochastic volatility, (ii) stochastic covariance between returns and volatility, and (iii) a market price of \belief risk." For the special case where the drift takes only two values, we provide an option pricing formula using Fourier Transforms. The model calibrated to 1960-1998 S&P 500 real earnings growth shows that investors' uncertainty explains intertemporal variation in the slope and curvature of implied volatility curves as well as the conditional moments of the state-return density obtained from option data. The calibrated model generates hedging `violations' of onefactor markov and deterministic volatility function models with roughly empirical frequencies. JEL Classi cation: G12, G13