What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk?
Princeton University - Bendheim Center for Finance
Michael B. Imerman
Lehigh University; Princeton University
Princeton University - Department of Operations Research & Financial Engineering (ORFE)
May 31, 2013
This paper examines the volatility risk premium, defined as the difference between expected future volatility under the risk-neutral measure and the expectation under the physical measure. This risk premium represents the price of volatility risk in financial markets. It is standard to use the VIX volatility index to proxy the expectation under the risk-neutral measure. Estimation under the physical measure is less straightforward. Using ultra-high-frequency transaction data on SPDR, the S&P500 ETF, we implement a novel approach for estimating integrated volatility on the frequency domain which allows us to isolate possibly autocorrelated microstructure noise from the true volatility. Once we compute the volatility risk premium, we perform a comprehensive econometric analysis to help identify its determinants. We find that analyzing the sign and magnitude components of the volatility risk premium provides greater insight into the underlying economic drivers, most notably supply and demand forces in the market for hedging tail risk as well as the role of intermediaries in this market. Our results are consistent with previous studies and are able to reconcile different interpretations of the volatility risk premium in the literature.
Number of Pages in PDF File: 61
Keywords: volatility risk premium, integrated volatility, ultra-high-frequency data, microstructure noise, Fourier transform, tail risk
JEL Classification: C01, C58, G12
Date posted: March 17, 2013 ; Last revised: July 9, 2013
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