Uncertainty Premia for Small and Large Risks
89 Pages Posted: 24 Apr 2015 Last revised: 3 Jan 2024
Date Written: January 1, 2024
Abstract
We show that the effect of smooth ambiguity aversion on large risks, those that are independent of the holding period, is of first-order importance, in contrast to risks that are proportional to the holding period. To test for the difference in the effect of ambiguity aversion on the two types of risk, we develop an ex-ante measure of the price of uncertainty based on changes in the option-implied concavity of preferences around scheduled macroeconomic announcements. As predicted by our model, we find that such concavity increases ahead of announcements, which represent large risks. We also provide an estimate of the coefficient of relative ambiguity aversion based on a simple model with smooth ambiguity aversion preferences and show how uncertainty varies across different announcements. Our results suggest that the macroeconomic announcement premium arises at least partly because of an increase in the price of uncertainty. One implication is that a fundamental benefit of securities markets is that they break large risks into small ones by allowing frequent trading, thereby reducing discount rates.
Keywords: Uncertainty, price of risk, price of uncertainty, risk aversion, ambiguity aversion, options
JEL Classification: G12
Suggested Citation: Suggested Citation