Learning, Confidence, and Option Prices

Abstract

The asset-market evidence suggests that investors are concerned with large downward moves in equity prices, which occur about once every one or two years in the data. This evidence is puzzling as there are no concurrent jumps in macroeconomic fundamentals at such frequencies. I estimate a confidence-risk model where consumption shocks are Gaussian, and agents use a constant gain specification to learn about the unobserved expected growth from the cross-section of signals. Investors’ uncertainty (confidence measure) is time-varying and is subject to jumps, which endogenously leads to large negative moves in equity prices and expensive out-of-the-money puts. The model provides a good fit to macroeconomic, asset-price, and forecast data.

Keywords: option prices, jumps, recursive utility, long-run risks, confidence, learning

JEL Classification: E44, G13, C58