Essays in asset pricing

My dissertation consists of two essays. The essays analyze the equilibrium impact on asset risk premia of variation in the level of uncertainty and the risk of sizeable non-Gaussian (jump) shocks to important macroeconomic variables. The essays highlight the importance of uncertainty channels for understanding and quantitatively capturing the large and volatile risk premium embedded in equity index options, and the connection between variation in this option premium and expected equity returns. Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. In the first essay we demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks rnodel generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents\u27 views of economic uncertainty and prices. In the second essay, I argue that time-varying Knightian uncertainty regarding economic fundamentals plays a central role in accounting for the equity premium, return volatility and the large, volatile variance premium embedded in equity index option prices. I build a general equilibrium framework that incorporates time-varying Knightian uncertainty about diffusive and jump shocks to the level and volatility of long-run cash-flow growth rates. A calibrated model is shown to capture the variance premium and option skew while simultaneously matching the moments of cash-flows and stock returns. The model indicates that fluctuations in the variance premium strongly reflect changes in the level of Knightian uncertainty and should predict monthly stock returns, consistent with recent empirical evidence