Growth Uncertainty, Rational Learning, and Option Prices

We examine implications of introducing parameter uncertainty in endowment and production economies for index option premiums. We estimate two-state models of consumption and productivity growth using post-war U.S. data and allow for rational learning about unknown persistence of economic growth. Endogenous feedback from productivity news to consumption magnifies the effect of parameter learning on marginal utility, whereas exogenously determined cash-flows dampen the possibility of endogenous response. Consequently, a production economy with learning better captures stylized facts, explaining the variance premium and option prices. The model’s ability to match empirical moments is robust to feeding actual productivity data and alternative priors