NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Alexander David, Pietro Veronesi

NBER Working Paper No. 16764
Issued in February 2011
NBER Program(s):   AP   EFG   ME

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.

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This paper was revised on December 11, 2013

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