Macroeconomic Uncertainty and Fear Measures Extracted from Index Options

Abstract:     
We demonstrate that about half the time series variation in two popular market-wide fear indices extracted from S&P 500 index options prices -- the at-the-money implied volatility (ATMIV), and the ratio of implied volatilities of out-of-the-money puts and calls (P/C) -- can be explained by investors' learning of the state of fundamentals through business cycles. Our model ATMIV is higher during periods of higher uncertainty about earnings growth and captures the information in standard macroeconomic variables in the volatility literature. The model P/C is higher during periods of higher expected earnings growth, but varies quite significantly with inflation expectations. It makes investor sentiment measures from the empirical behavioral finance literature insignificant. As further support for the learning mechanism we demonstrate the ability of our model to explain (i) the positive relation between volatility and the volatility of volatility, (ii) the puzzling change in sign of the relation between P/E and put-call ratios in 1994, and (iii) The negative (positive) association between short rates and ATMIV in periods of stimulative (non-stimulative) monetary policy. None of these three stylized facts can be explained by standard option pricing models (such as Heston's stochastic volatility model).

JEL Classifications: G12,G13

Working Paper Series