Ambiguity Aversion and Variance Premium

Jianjun Miao, Bin Wei, and Hao Zhou
Working Paper 2018-14
December 2018

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This paper offers an ambiguity-based interpretation of 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 approach endogenously generates variance premium without imposing exogenous stochastic volatility or jumps in consumption process. Such a framework can reasonably match the mean variance premium as well as the mean equity premium, equity volatility, and the mean risk-free rate in the data. We find that about 96 percent of the mean variance premium can be attributed to ambiguity aversion. Applying the model to historical consumption data, we find that variance premium mostly captures depressions, deep recessions, and financial panics, with a postwar peak in 2009.

JEL classification: G12, G13, D81, E44

Key words: ambiguity aversion, learning, variance premium, regime shift, belief distortion

The views expressed here are those of the authors and not necessarily those of the Federal Reserve Banks of Atlanta and New York, the Federal Reserve Board or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Jianjun Miao, Department of Economics, Boston University, 270 Bay State Road, Boston MA 02215, USA, 617-353-6675,; Bin Wei, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8913,; or Hao Zhou, PBC School of Finance, Tsinghua University, 43 Chengfu Road, Haidian District, Beijing, 100083, China,
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