The Policy Risk Premium in Equity Derivatives

Abstract

This paper introduces a model that allows to measure the impact of policy risk on the dynamics of the S&P 500 index using option data. I quantify the impact of policy risk on the whole P-distribution of assets, not just on volatility, as most literature on policy risk does. I document that this type of risk is priced and has a sizeable impact on expected returns, volatilities, skewness and kurtosis. A one percent increase in the Economic Policy Uncertainty index leads to a 2.25 percentage points increase in the Equity Risk Premium.

Keywords: political risk, options, equity derivatives, unscented kalman filter, asset pricing, equity risk premium, kalman filter

JEL Classification: G12, G13