Uncertainty Premia for Small and Large Risks
50 Pages Posted: 24 Apr 2015 Last revised: 26 Jan 2020
Date Written: January 22, 2020
We construct an ex-ante measure of the price of risk based on changes in the option-implied concavity of preferences around scheduled macroeconomic announcements. We motivate this measure using an example of smooth ambiguity-averse preferences where the intuition is particularly clear. Our model shows that the effect of smooth ambiguity aversion on large risks, those that are independent of the holding period, should be of first-order importance, in contrast to risks that are proportional to the holding period. We test for the difference in the effect of ambiguity aversion on the two types of risk by studying the implied concavity of preferences, and find that such concavity increases ahead of announcements, which represent large risks. Our results suggest that the macroeconomic announcement premium arises because of an increase in the price of risk, as opposed to an increase in the quantity of risk or on-average positive in-sample news. One implication is that a fundamental benefit of securities markets is that they break large risks into small ones by allowing frequent trading, thereby reducing discount rates.
Keywords: Uncertainty, price of risk, risk aversion, ambiguity aversion, options
JEL Classification: G12
Suggested Citation: Suggested Citation