Uncertainty, Time-Varying Fear, and Asset Prices



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    • Itamar Drechsler is at Stern School of Business, New York University. I my grateful to my committee, Amir Yaron (Chair), Rob Stambaugh, and Stavros Panageas. I also thank Andy Abel, Ravi Bansal (discussant), Joao Gomes, Lars Hansen, Philipp Illeditsch, Jakub Jurek, Richard Kihlstrom, Feifei Li (discussant), Jun Liu, Nick Roussanov, Freda Song, Nick Souleles, Luke Taylor, Jessica Wachter, Paul Zurek, and seminar participants at Wharton, Chicago Booth School of Business, Columbia GSB, Princeton, NYU Stern, the University of Rochester, the 2009 Western Finance Association meeting (San Diego), the 2009 Stanford Institute for Theoretical Economics (SITE) workshop, and the 2010 American Finance Association meeting (Atlanta) for helpful comments. I thank Nim Drechsler and contacts at Citigroup and CSFB for options data. I am also indebted to the Editor, Cam Harvey, and to an anonymous referee for numerous comments that significantly improved the paper.


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.