Growth Uncertainty, Rational Learning, and Option Prices

50 Pages Posted: 2 Oct 2020 Last revised: 3 Dec 2020

See all articles by Mykola Babiak

Mykola Babiak

Lancaster University Management School

Roman Kozhan

University of Warwick - Warwick Business School

Date Written: December 3, 2020

Abstract

We demonstrate that incorporating parameter learning into a production economy can capture salient properties of the variance premium and index option prices with empirically consistent equity returns, the risk-free rate, and macroeconomic quantities. In a model estimated on post-WWII U.S. data, the investor learns about the true parameters governing the persistence, mean, and volatility of productivity growth. Rational belief updating amplifies the impact of shocks on prices and conditional moments. The agent, in turn, pays a large premium for variance swaps and options because they hedge his concerns about future revisions, particularly concerning the mean and volatility of productivity growth.

Keywords: Uncertainty, Rational Learning, Business Cycles, Variance Premium, Implied Volatilities

JEL Classification: D83, E13, E32, G12

Suggested Citation

Babiak, Mykola and Kozhan, Roman, Growth Uncertainty, Rational Learning, and Option Prices (December 3, 2020). Available at SSRN: https://ssrn.com/abstract=3675548 or http://dx.doi.org/10.2139/ssrn.3675548

Mykola Babiak (Contact Author)

Lancaster University Management School ( email )

Department of Accounting and Finance
Lancaster University Management School
Lancaster, LA1 4YX
United Kingdom
+44 (0) 7512 209090 (Phone)

HOME PAGE: http://sites.google.com/site/mykolababiak/home

Roman Kozhan

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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