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Learning and forecasts about option returns through the volatility risk premium

Alejandro Bernales (), Louisa Chen and Marcela Valenzuela

Journal of Economic Dynamics and Control, 2017, vol. 82, issue C, 312-330

Abstract: We use learning in an equilibrium model to explain the puzzling predictive power of the volatility risk premium (VRP) for option returns. In the model, a representative agent follows a rational Bayesian learning process in an economy under incomplete information with the objective of pricing options. We show that learning induces dynamic differences between probability measuresP and Q, which produces predictability patterns from the VRP for option returns. The forecasting features of the VRP for option returns, obtained through our model, exhibit the same behaviour as those observed in an empirical analysis with S&P 500 index options.

Keywords: Option returns; Volatility risk premium; Bayesian learning; Predictability; Dynamic equilibrium model (search for similar items in EconPapers)
JEL-codes: D83 G12 G13 G14 G17 (search for similar items in EconPapers)
Date: 2017
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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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Handle: RePEc:eee:dyncon:v:82:y:2017:i:c:p:312-330