When Uncertainty Blows in the Orchard: Comovementand the Equilibrium Volatility Risk Premia

In a Lucas orchard with heterogeneous beliefs, we study the link between market-wide uncertainty, difference of opinionsand co-movement of stock returns. We show that this link plays an important role in explaining the dynamics of equilibriumvolatility and correlation risk premia. In our economy, uncertainty is linked to both firm-specific and market-wide signals.These two uncertainty channels drive the co-movement of stock returns even when dividends are weakly dependent: Greatersubjective uncertainty or higher disagreement on the market-wide signal imply a larger correlation of beliefs, a strongerco-movement of stock returns, and a substantial correlation risk premium generated by the endogenous optimal risksharingamong investors. These features are different and ancillary to the pure market-clearing effects distinct to anymultiple-trees economy. We test empirically the implications of the model-implied co-movement channels and derive testablepredictions for the dynamics and the cross-sectional features of index and individual stock options.[...]