Unknown Unknowns: Vol-of-Vol and the Cross-Section of Stock Returns

Abstract:     
We develop a measure for uncertainty about expected stock returns that is derived directly from the well-developed literature on second-order utility: the volatility of option-implied volatility (vol-of-vol). High vol-of-vol stocks signal more of such uncertainty, and robustly underperform low vol-of-vol stocks by 10 percent per year. The vol-of-vol effect is not driven by optimism bias or arbitrage frictions, exposures to jump risk or stochastic volatility risk, or by higher-order risk. Moreover, statistical tests cannot confirm that vol-of-vol is a priced risk factor in traditional asset pricing models. Our results seem inconsistent with rational pricing of uncertainty by a representative agent.

Number of Pages in PDF File: 69

Keywords: asset pricing, stock returns, uncertainty

JEL Classification: G10, G12, D80

working papers series