Uncertainty, Time-Varying Fear, and Asset Prices
I construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk-free rate. A representative investor makes consumption and portfolio choice decisions that are robust to his uncertainty about the true economic model. He pays a large premium for index options because they hedge important model misspecification concerns, particularly concerning jump shocks to cash flow growth and volatility. A calibration shows that empirically-consistent fundamentals and a reasonable level of model uncertainty explain option prices and the variance premium. Time variation in investor uncertainty generates variance premium fluctuations and helps explain their power to predict stock returns.