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Investors' and Central Bank's Uncertainty Embedded in Index Options

Alexander David¹; Pietro Veronesi^2,3

¹ University of Calgary · ² Center for Economic and Policy Research · ³ University of Chicago

Shocks to equity options' implied volatility are followed by persistently lower short-term rates. Shocks to puts' over calls' out-of-the-money implied volatilities (P/C) are followed by persistently higher rates. Stock and Treasury bond implied volatilities, which measure market and policy uncertainty, are countercyclical, while P/C, which measures downside risk, is procyclical. An equilibrium model in which investors and the central bank learn about composite regimes of economic and policy variables explains these dynamics, linking them to a learning-based, forward-looking Taylor rule. Survey data support our model's predictions on the effect of uncertainty on the level and fluctuations of implied volatilities.

DOI

10.1093/rfs/hhu024

Volume

27 (6)

Pages

1661-1716

Language

en

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BibTeX

Sources

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