Ambiguity Aversion and Variance Premium

Jianjun Miao, Associate Professor of Economics at Boston University, 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 uncertain economic regimes. He and his colleagues endogenously generate 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. They fi nd that about 96 percent of the mean variance premium can be attributed to ambiguity aversion. Applying the model to historical consumption data, they fi nd that variance premium mostly captures depressions, deep recessions, and financial panics, with a postwar peak in 2009. This lecture is a part of the Workshop on Ambiguity and Robustness in Macroeconomics and Finance.

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