Volatility Disagreement and Equilibrium Volatility Trading
51 Pages Posted: 29 Nov 2023
Date Written: November 6, 2023
We develop a dynamic equilibrium model in which investors disagree on future volatility and trade volatility derivatives to hedge their stock positions and speculate on their beliefs. We find that in equilibrium investors trade less volatility derivatives in more volatile periods, and they may also do so when they disagree more. The variance risk premium is negative on average, but it becomes positive when the market tends to underestimate future volatility. Volatility disagreement generates time-variation in the leverage effect, which gets stronger in more volatile periods, consistent with empirical evidence. Our framework, which can also incorporate an aggregate volatility bias, reconciles other key aspects of volatility derivatives and stock markets in a unified setting.
Keywords: Volatility disagreement, volatility trading, volatility derivatives market, variance swaps, variance risk premium, leverage effect, equilibrium asset prices
JEL Classification: G11, G12, G13, D53
Suggested Citation: Suggested Citation