When Uncertainty Blows in the Orchard: Comovement and Equilibrium Volatility Risk Premia

Abstract

We produce novel evidence for an equilibrium link between investors' disagreement, the market price of volatility and correlation, and the differential pricing of index and individual equity options. We show that belief disagreement is positively related to (i) the wedge between index and individual volatility risk premia, (ii) the different slope of the smile of index and individual options and (iii) the correlation risk premium. Priced disagreement risk also explains returns of option volatility and correlation trading strategies in a way that is robust to the inclusion of other risk factors and different market conditions.

Keywords: Disagreement, Correlation Risk Premium, Uncertainty, Volatility Risk Premium

JEL Classification: D80, G12, G13