Abstract

http://ssrn.com/abstract=2234438
 
 

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What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk?


Jianqing Fan


Princeton University - Bendheim Center for Finance

Michael B. Imerman


Lehigh University; Princeton University

Wei Dai


Princeton University - Department of Operations Research & Financial Engineering (ORFE)

May 31, 2013


Abstract:     
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

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Date posted: March 17, 2013 ; Last revised: July 9, 2013

Suggested Citation

Fan, Jianqing and Imerman, Michael B. and Dai, Wei, What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk? (May 31, 2013). Available at SSRN: http://ssrn.com/abstract=2234438 or http://dx.doi.org/10.2139/ssrn.2234438

Contact Information

Jianqing Fan
Princeton University - Bendheim Center for Finance ( email )
26 Prospect Avenue
Princeton, NJ 08540
United States
609-258-7924 (Phone)
609-258-8551 (Fax)
HOME PAGE: http://orfe.princeton.edu/~jqfan/
Michael B. Imerman (Contact Author)
Lehigh University ( email )
Bethlehem, PA 18015
United States
610-758-6380 (Phone)
Princeton University ( email )
Sherrerd Hall
Princeton, NJ 08544
United States
609-258-1889 (Phone)

Wei Dai
Princeton University - Department of Operations Research & Financial Engineering (ORFE) ( email )
Princeton, NJ
United States
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