Growth Uncertainty, Rational Learning, and Option Prices

Mykola Babiak and Roman Kozhan

CERGE-EI Working Papers from The Center for Economic Research and Graduate Education - Economics Institute, Prague

Abstract: We demonstrate that incorporating parameter learning into a production economy can capture salient properties of the variance premium and index option prices with empirically consistent equity returns, the risk-free rate, and macroeconomic quantities. In a model estimated on post-WWII U.S. data, the investor learns about the true parameters governing the persistence, mean, and volatility of productivity growth. Rational belief updating amplifies the impact of shocks on prices and conditional moments. The agent, in turn, pays a large premium for variance swaps and options because they hedge his concerns about future revisions, particularly concerning the mean and volatility of productivity growth.

Keywords: uncertainty; rational learning; business cycles; variance premium; implied volatilities (search for similar items in EconPapers)
JEL-codes: D83 E13 E32 G12 (search for similar items in EconPapers)
Date: 2021-01
New Economics Papers: this item is included in nep-fdg, nep-mac and nep-ore
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