Uncertainty, fear and asset prices

Itamar Drechsler, in his paper "Uncertainty, time varying fear, and asset prices" in the Journal of Finance addresses some of the key issues on risk and return that I have been grappling with recently. Dreschsler creates and tests a model that looks at uncertainty to explain features in equity index options, the large premium in price often referred to as the variance premium, and the shape of the volatility surface or skew in out of the money options especially puts. 

The model hypothesizes that when there is a large increase in model uncertainty there will be a higher  premium in option prices. Model errors or errors in our forecast of the economy will have an important impact on asset prices. If there are jumps in price that are not fully incorporated in models, investors will need to increase the price they are willing to pay for options. One way to measure uncertainty is to proxy model error or uncertainty through the dispersion of forecasts for GDP. If there is greater dispersion, then there will be more likely errors in the underlying understanding of the economy and cash flow growth. The result of more uncertainty will be a change in the risk premium for purchasing index options. Through looking at different measure of economic uncertainty, the author was able to tie the variance premium and skew to specific macro variables. 

These results would seem to most traders as obvious, but it provides good explanation for what academics have called anomalies. When uncertainty goes up, we will seem the risk premium increase in index prices.