Why Do Rational Investors Like Variance at the Peak of a Crisis? A Learning-Based Explanation

58 Pages Posted: 14 Nov 2021 Last revised: 1 Aug 2022

See all articles by Mohammad Ghaderi

Mohammad Ghaderi

University of Kansas - School of Business

Mete Kilic

University of Southern California - Marshall School of Business

Sang Byung Seo

University of Wisconsin - Madison

Date Written: November 11, 2021

Abstract

Investors' learning can drastically alter the dynamics of the variance risk premium: it no longer increases as economic conditions deteriorate but exhibits a highly nonlinear pattern, occasionally even turning negative. We demonstrate this intuition using a model where investors rationally form their belief about the hidden economic state. When the "bad" state becomes probable, investors start liking high future variance because it overwhelmingly correlates with lower marginal utility. This mechanism rationalizes the puzzling observation that risk-neutral volatility falls short of physical volatility at the peak of a severe crisis. Our results shed light on the interpretation of good economic uncertainty.

Keywords: negative variance risk premium, Bayesian learning, rational investors, good uncertainty, crisis dynamics

JEL Classification: G12, G01

Suggested Citation

Ghaderi, Mohammad and Kilic, Mete and Seo, Sang Byung, Why Do Rational Investors Like Variance at the Peak of a Crisis? A Learning-Based Explanation (November 11, 2021). Available at SSRN: https://ssrn.com/abstract=3961315 or http://dx.doi.org/10.2139/ssrn.3961315

Mohammad Ghaderi

University of Kansas - School of Business ( email )

1654 Naismith Dr.
Lawrence, KS 66045
United States

HOME PAGE: http://sites.google.com/site/mohaghaderi

Mete Kilic

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA California 90089
United States

Sang Byung Seo (Contact Author)

University of Wisconsin - Madison ( email )

975 University Avenue
Madison, WI 53706-1324

HOME PAGE: http://sites.google.com/site/sangbyungseo

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