The Term Structure of Variance Swaps, Risk Premia and the Expectation Hypothesis

Abstract:     
We study the term structure of variance swaps, which are popular volatility derivative contracts. A model-free analysis reveals a significant jump risk component embedded in variance swaps. The variance risk premium is negative and has a downward sloping term structure. Variance risk premia due to negative jumps present similar features in quiet times but have an upward sloping term structure in turbulent times. This suggests that short-term variance risk premia mainly reflect investors' fear of a market crash. Theoretically, the Expectation Hypothesis does not hold, but biases and inefficiencies are modest for short time horizons. A simple trading strategy with variance swaps generates significant returns.

Number of Pages in PDF File: 61

Keywords: variance swap, stochastic volatility, likelihood approximation, term structure, equity risk premium, variance risk premium, expectation hypothesis

JEL Classification: C51, G12, G13

working papers series