Investors' and Central Bank's Uncertainty Embedded in Index Options
University of Calgary - Haskayne School of Business
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
January 21, 2014
Review of Financial Studies (Forthcoming)
Shocks to equity options’ ATM implied volatility (ATMIV) are followed by persistently lower short-term rates. Shocks to the ratio of OTM puts’ over OTM calls’ implied volatilities (P/C) are followed by persistently higher rates. The stock’s and Treasury bond’s ATMIV indices, which measure market and policy uncertainty, are countercyclical while the P/C index, which measures downside risk, is pro-cyclical. An equilibrium model in which investors and the central bank learn about composite regimes of economic and policy variables explains these dynamics, linking them to a learning based, forward-looking Taylor rule. Survey data support our model’s predictions on the impact of uncertainty on the level and fluctuations of implied volatilities.
Number of Pages in PDF File: 73
Keywords: Fear measures, index options, central bank uncertainty, investors' uncertainty, predicting interest rates, nonlinearities, volatility of volatility, volatility premium, monetary policy
JEL Classification: G12, E4, E5Accepted Paper Series
Date posted: January 25, 2011 ; Last revised: January 28, 2014
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