Journal Article

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

Alexander David and Pietro Veronesi

in The Review of Financial Studies

Published on behalf of The Society for Financial Studies

Volume 27, issue 6, pages 1661-1716
Published in print June 2014 | ISSN: 0893-9454
Published online April 2014 | e-ISSN: 1465-7368 | DOI: http://dx.doi.org/10.1093/rfs/hhu024
Investors' and Central Bank's Uncertainty Embedded in Index Options

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  • Economics
  • Money and Interest Rates
  • Monetary Policy, Central Banking, and the Supply of Money and Credit

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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.

Keywords: G12; E4; E5

Journal Article.  25304 words.  Illustrated.

Subjects: Economics ; Money and Interest Rates ; Monetary Policy, Central Banking, and the Supply of Money and Credit

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