Variance Risk Premium Demystified

Abstract:     
We study the dynamics and cross-sectional properties of the variance risk premia embedded in options on stocks and indices, approximated by the synthetic variance swap returns. Several important stylized facts and contributions arise. First, variance risk premia for indices are systematically larger (more negative) than for individual securities. Second, there are systematic cross-sectional differences in the price of variance in individual stocks. Linking variance swaps to firm size/book-to-market, and stock turnover characteristics, an investor gains access to several lucrative long-short strategies with Sharpe Ratios around 2.85. Third, principal component analysis reveals at most one important factor driving both stock and variance swap returns, which corresponds to the traditional market factor. For the remainder of the dynamics, the stock and its variance processes are nearly linearly independent. Fourth, we find the leverage effect through analysis of the relationship between the variance risk premium and stock to variance correlation. The systematic (market factor) part of the leverage effect provides additional evidence of the existence of one factor common to both variance swaps and stocks, but the contribution of the market risk premium to the total variance premium is very small. These findings stress the importance of using variance-based instruments in the portfolio of an investor.

Number of Pages in PDF File: 32

Keywords: variance risk premium, variance swap, individual options, variance factors

JEL Classification: C21, G13, G14

working papers series