October 22, 2019
We provide evidence that agents have slow moving beliefs about stock market volatility. This is supported in survey data and is also reflected in firm level option prices. We embed these expectations into an asset pricing model and show that we jointly explain the following stylized facts (some of which are novel to this paper): when volatility increases the equity and variance risk premiums fall or stay flat at short horizons, despite higher future risk; these premiums appear to rise at longer horizons after future volatility has subsided; strategies that time volatility generate alpha; the variance risk premium forecasts stock returns more strongly than either realized variance or risk-neutral variance (VIX); changes in volatility are negatively correlated with contemporaneous returns.