Ambiguity Aversion and Variance Premium

41 Pages Posted: 31 Jan 2019 Last revised: 21 Feb 2019

See all articles by Jianjun Miao

Jianjun Miao

Boston University - Department of Economics

Bin Wei

Federal Reserve Bank of Atlanta

Hao Zhou

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: 2018-12-01

Abstract

This paper offers an ambiguity-based interpretation of variance premium—the difference between risk-neutral and objective expectations of market return variance—as a compounding effect of both belief distortion and variance differential regarding the uncertain economic regimes. Our approach endogenously generates variance premium without imposing exogenous stochastic volatility or jumps in consumption process. Such a framework can reasonably match the mean variance premium as well as the mean equity premium, equity volatility, and the mean risk-free rate in the data. We find that about 96 percent of the mean variance premium can be attributed to ambiguity aversion. Applying the model to historical consumption data, we find that variance premium mostly captures depressions, deep recessions, and financial panics, with a postwar peak in 2009.

Keywords: ambiguity aversion, learning, variance premium, regime shift, belief distortion

JEL Classification: D81, E44, G12, G13

Suggested Citation

Miao, Jianjun and Wei, Bin and Zhou, Hao, Ambiguity Aversion and Variance Premium (2018-12-01). FRB Atlanta Working Paper No. 2018-14. Available at SSRN: https://ssrn.com/abstract=3326325 or http://dx.doi.org/10.29338/wp2018-14

Jianjun Miao (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)

HOME PAGE: http://people.bu.edu/miaoj

Bin Wei

Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

HOME PAGE: http://https://www.frbatlanta.org/research/economists/wei-bin.aspx

Hao Zhou

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengfu Road
Haidian District
Beijing, 100083
China
86-10-62790655 (Phone)

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