ShanghaiTech SEM Working Paper No. 2018-002
Ming Guo
ShanghaiTech University - School of Entrepreneurship and Management
Hao Zhou
Tsinghua University - PBC School of Finance
Abstract
This paper develops a dynamic model of prices and trades in a risky security and an option, where agents use different subjective likelihood functions to interpret a public signal, but they are initially uncertain about the signal’s mean or precision. Such a framework of subjective model uncertainty can explain the seemingly overpriced options and endogenously generate variance risk premium (VRP). However, the model yield contrasting implications on whether options and VRP are spanned and on whether trading volume is positively related to VRP. Empirical evidence largely supports sub-jective model uncertainty about the signal precision in major futures markets.
Keywords: Subjective model uncertainty, signal mean and precision, option-implied uncertainty premium, variance risk premium, trading volume.
JEL Classification: G11, G12, G13.
Date Written: March 28, 2018
Available at SSRN: http://ssrn.com/abstract=3159702
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