Volatility Disagreement and Asset Prices

Abstract

We study a dynamic equilibrium model in which investors disagree on future volatility and trade volatility derivatives to hedge stock positions and speculate. On average, volatility disagreement makes the variance risk premium more negative. However, volatility trading enables a risk transfer among investors that turns the variance risk premium positive when the market underestimates future volatility. Under higher volatility, investors trade fewer volatility derivatives as these become too risky. These economic mechanisms shed light on empirical regularities during market turmoil. Volatility disagreement also lowers the stock market valuation, increases market volatility, and generates time-variation in the leverage effect.

Keywords: Volatility disagreement, volatility trading, volatility derivatives market, variance swaps, variance risk premium, leverage effect, equilibrium asset prices

JEL Classification: G11, G12, G13, D53