Abstract: In an incomplete information model, investors' uncertainty about
the underlying drift rate of a firm's fundamentals affects option prices
through (i) endogenous and beliefdependent stochastic
volatility, (ii) stochastic covariance between returns and
volatility, and (iii) a market price of "belief risk." For the
special case where the drift takes only two values,
we provide an option pricing formula using Fourier Transforms.
The model calibrated to 19601998 S&P 500 real earnings growth shows
that investors' uncertainty explains intertemporal variation in the
slope and curvature of implied volatility curves as well as the
conditional moments of the statereturn density obtained from option
data. The calibrated model generates hedging `violations' of
onefactor markov and deterministic volatility function models with
roughly empirical frequencies.
Keywords: Uncertainty, changing returnvolatility correlation, belief risk, putcall ratio, butterfly spread, hedging violations
Full paper (670 KB PDF)
 Full paper (849 KB Postscript)
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Last update: October 20, 1999
