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Ambiguity Aversion and the Variance Premium

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  • Jianjun Miao

    (Department of Economics, Boston University, 270 Bay State Road, Boston MA 02215, USA2ICFS, Southwestern University of Finance and Economics, China3CEMA, Central University of Finance and Economics, China)

  • Bin Wei

    () (Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309, USA)

  • Hao Zhou

    (PBC School of Finance, Tsinghua University, 43 Chengfu Road, Haidian District, Beijing 100083, China)

Abstract

This paper offers an ambiguity-based interpretation of the variance premium — the difference between risk-neutral and objective expectations of market return variance — as a compounding effect of both belief distortion and variance differential regarding the uncertain economic regimes. Our calibrated model can match the variance premium, the equity premium, and the risk-free rate in the data. We find that about 97% of the mean–variance premium can be attributed to ambiguity aversion. A three-way separation among ambiguity aversion, risk aversion, and intertemporal substitution, permitted by the smooth ambiguity preferences, plays a key role in our model’s quantitative performance.

Suggested Citation

  • Jianjun Miao & Bin Wei & Hao Zhou, 2019. "Ambiguity Aversion and the Variance Premium," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 9(02), pages 1-36, June.
  • Handle: RePEc:wsi:qjfxxx:v:09:y:2019:i:02:n:s2010139219500034
    DOI: 10.1142/S2010139219500034
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Qi Nan Zhai, 2015. "Asset Pricing Under Ambiguity and Heterogeneity," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 16, July-Dece.
    2. Gonçalo Faria & João Correia-da-Silva, 2014. "A closed-form solution for options with ambiguity about stochastic volatility," Review of Derivatives Research, Springer, vol. 17(2), pages 125-159, July.
    3. Panagiotidis, Theodore & Printzis, Panagiotis, 2020. "What is the investment loss due to uncertainty?," Global Finance Journal, Elsevier, vol. 45(C).
    4. Park, Yang-Ho, 2015. "Volatility-of-volatility and tail risk hedging returns," Journal of Financial Markets, Elsevier, vol. 26(C), pages 38-63.
    5. Danilo Cascaldi-Garcia & Deepa Dhume Datta & Thiago Revil T. Ferreira & Olesya V. Grishchenko & Mohammad R. Jahan-Parvar & Juan M. Londono & Francesca Loria & Sai Ma & Marius del Giudice Rodriguez & J, 2020. "What is Certain about Uncertainty?," International Finance Discussion Papers 1294, Board of Governors of the Federal Reserve System (U.S.).
    6. Lin, Mei-Chen, 2018. "The impact of aggregate uncertainty on herding in analysts' stock recommendations," International Review of Financial Analysis, Elsevier, vol. 57(C), pages 90-105.
    7. Panagiotidis, Theodore & Printzis, Panagiotis, 2020. "What is the investment loss due to uncertainty?," Global Finance Journal, Elsevier, vol. 45(C).
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    9. Ariel M. Viale & Antoine Giannetti & Luis Garcia-Feijoó, 2020. "The stock market’s reaction to macroeconomic news under ambiguity," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 34(1), pages 65-97, March.
    10. Qi Nan Zhai, 2015. "Asset Pricing Under Ambiguity and Heterogeneity," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2015, September.
    11. Konstantinidi, Eirini & Skiadopoulos, George, 2016. "How does the market variance risk premium vary over time? Evidence from S&P 500 variance swap investment returns," Journal of Banking & Finance, Elsevier, vol. 62(C), pages 62-75.
    12. Aramonte, Sirio, 2014. "Macroeconomic uncertainty and the cross-section of option returns," Journal of Financial Markets, Elsevier, vol. 21(C), pages 25-49.

    More about this item

    Keywords

    Ambiguity aversion; learning; variance premium; regime-shift; belief distortion;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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