Observable Long-Run Ambiguity and Long-Run Risk

Abstract

We document that fear about misspecified economic and central bank policies explain 45% of variations in bond option implied volatilities and interest rate volatilities. We endogenize this empirical pattern with a parsimonious equilibrium asset pricing model. In equilibrium, volatility is endogenously driven by fear of not knowing the data generating process that drives future economic and future central bank policies. An increase in either of these two uncertainties steepens the yield curve and increases the volatility in asset and option markets. A structural estimation of the equilibrium model explains the upward sloping term structures of interest rates, bond volatility, and option volatility, with only four in real-time observable economic and central bank related risk and uncertainty factors. The study ends with highlighting an inverse relationship between interest rates and volatility disparity from fundamentals during the policy hiking period of 2004-2007 and during QE1.