Abstract
Investors are willing to pay a premium to protect their gains against bad states of the world, when uncertainty and stock volatility tend to increase. In the data, volatility risk premia of individual stocks exhibit two distinct features: In the cross-section, the sign of the risk premium depends crucially on the firm’s leverage and in the time-series, there exists a counter-cyclical factor which is common across all stocks. I find that empirical proxies for investors’ uncertainty about expected growth rates and macro-economic uncertainty are priced risk factors that convey information over and above that contained in other standard factors to explain the cross-section and time-series of these risk premia. In addition, I present predictability evidence from the individual volatility risk premia for stock excess returns and corporate credit spreads. I address this empirical evidence in a Lucas orchard with heterogeneous beliefs and stochastic macro-economic uncertainty and show how the two different sources of risk account for the pricing of the cross-section of stock options and in particular their embedded volatility risk premia. In the economy I posit, levered trees have the option to default which leads to a non-monotonic link between return and volatility. The interplay between the default option in stock returns coupled with disagreement and economic uncertainty allows for a positive or negative risk-neutral skewness, depending on leverage. Calibrating the model, I show that the wedge between the physical and risk-neutral expected volatility is mainly driven by agents’ disagreement and economic uncertainty and that the model accounts for predictability of excess stock returns and corporate credit spreads.
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