The VIX, the Variance Premium and Stock Market Volatility
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
European Central Bank (ECB)
Columbia Business School Research Paper No. 13-32
We decompose the squared VIX index, derived from US S&P500 options prices, into the conditional variance of stock returns and the equity variance premium. We evaluate a plethora of state-of-the-art volatility forecasting models to produce an accurate measure of the conditional variance. We then examine the predictive power of the VIX and its two components for stock market returns, economic activity and financial instability. The variance premium predicts stock returns while the conditional stock market variance predicts economic activity and has a relatively higher predictive power for financial instability than does the variance premium.
Number of Pages in PDF File: 38
Keywords: option implied volatility, realized volatility, VIX, variance risk premium, risk aversion, stock return predictability, risk-return trade-off, economic uncertainty, financial instability
JEL Classification: C22, C52, G12, E32
Date posted: April 17, 2013 ; Last revised: March 31, 2014
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