Subjective Model Uncertainty, Variance Risk Premium, and Speculative Trading
54 Pages Posted: 30 Jun 2013 Last revised: 29 Jul 2019
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Subjective Model Uncertainty, Variance Risk Premium, and Speculative Trading
Date Written: August 1, 2018
Abstract
This paper develops a dynamic model of prices and trades in a risky security and an option, where agents use different subjective likelihood functions to interpret a public signal, but they are initially uncertain about the signal precision or mean. Our model can explain the seemingly overpriced options and endogenously generate variance risk premium (VRP). However, subjective model uncertainty about the signal precision (mean) implies that options and VRP are unspanned (spanned) and that trading volume is negatively (positively) related to VRP. Empirical evidence largely supports subjective model uncertainty about the signal precision in major futures markets.
Keywords: Subjective model uncertainty, signal precision or mean, option-implied uncertainty premium, variance risk premium, trading volume.
JEL Classification: G11, G12, G13
Suggested Citation: Suggested Citation