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

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  • Alexander David
  • Pietro Veronesi

Abstract

Shocks to equity options' ATM implied volatility (ATMIV) are followed by persistently lower short-term rates. Shocks to the ratio of OTM puts' over OTM calls' implied volatilities (P/C) are followed by persistently higher rates. The stock's and Treasury-bond's ATMIV indices, which measure market and policy uncertainty, are counter-cyclical while the P/C index, which measures downside risk, is pro-cyclical. An equilibrium model where investors and the central bank learn about composite regimes on economic and policy variables explains these options' dynamics, linking them to a learning-based, forward-looking Taylor rule. The model produces several predictions on the relation between options, monetary policy variables, and beliefs that find support in the data.

Suggested Citation

  • Alexander David & Pietro Veronesi, 2011. "Investors' and Central Bank's Uncertainty Embedded in Index Options," NBER Working Papers 16764, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:16764
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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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