Learning and forecasts on option returns through the volatility risk premium

Alejandro, Bernales, Chen, Louisa and Valenzuela, Marcela (2017) Learning and forecasts on option returns through the volatility risk premium. Journal of Economic Dynamics and Control, 82. 312 -330. ISSN 0165-1889

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Abstract

We use learning in an equilibrium model to explain the puzzling predictive power of the volatility risk premium (VRP) for option returns. In the model, a representative agent follows a rational Bayesian learning process in an economy under incomplete information with the objective of pricing options. We show that learning induces dynamic differences between probability measuresP and Q, which produces predictability patterns from the VRP for option returns. The forecasting features of the VRP for option returns, obtained through our model, exhibit the same behaviour as those observed in an empirical analysis with S&P 500 index options.

Item Type: Article
Keywords: Option returns; Volatility risk premium; Bayesian learning; Predictability; Dynamic equilibrium model
Schools and Departments: School of Business, Management and Economics > Business and Management
Subjects: H Social Sciences > HG Finance > HG4001 Finance management. Business finance. Corporation finance
Depositing User: Joy Blake
Date Deposited: 25 Apr 2018 09:03
Last Modified: 02 Jul 2019 15:51
URI: http://sro.sussex.ac.uk/id/eprint/75402

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