The Skew Risk Premium in the Equity Index Market
University of Warwick, Warwick Business School
University of Warwick - Warwick Business School
University of Lugano - Institute of Finance; Ecole Polytechnique Fédérale de Lausanne - Swiss Finance Institute; Boston University - Department of Finance & Economics
November 27, 2012
Review of Financial Studies (2013), 26, 2174-2203
AFA 2011 Denver Meetings Paper
We measure the skew risk premium in the equity index market through the skew swap. We argue that just as variance swaps can be used to explore the relationship between the implied variance in option prices and realized variance, so too can skew swaps be used to explore the relationship between the skew in implied volatility and realized skew. Like the variance swap, the skew swap corresponds to a trading strategy, necessary to assess risk premia in a model-free way. We find that almost half of the implied volatility skew can be explained by the skew risk premium. We provide evidence that skew and variance premia are manifestations of the same underlying risk factor in the sense that strategies designed to exploit one of the risk premia but to hedge out the other make zero excess returns.
Number of Pages in PDF File: 34
Keywords: skew risk premium, variance risk premium, index options
JEL Classification: G10, G12, G13
Date posted: March 18, 2010 ; Last revised: October 4, 2014
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