Expected Stock Returns and Variance Risk Premia
Duke University - Finance; Duke University - Department of Economics; National Bureau of Economic Research (NBER)
Duke University - Economics Group
July 1, 2008
AFA 2008 New Orleans Meetings Paper
Review of Financial Studies, Forthcoming
Duke Department of Economics Research Paper No. 5
CREATES Research Paper No. 2008-48
Motivated by the implications from a stylized self-contained general equilibrium model incorporating the effects of time-varying economic uncertainty, we show that the difference between implied and realized variation, or the variance risk premium, is able to explain a non-trivial fraction of the time series variation in post 1990 aggregate stock market returns, with high (low) premia predicting high (low) future returns. Our empirical results depend crucially on the use of "model-free,'' as opposed to Black-Scholes, options implied volatilities, along with accurate realized variation measures constructed from high-frequency intraday, as opposed to daily, data. The magnitude of the predictability is particularly strong at the intermediate quarterly return horizon, where it dominates that afforded by other popular predictor variables, like the P/E ratio, the default spread, and the consumption-wealth ratio (CAY).
Number of Pages in PDF File: 41
Keywords: Equilibrium asset pricing, stochastic volatility, risk neutral expectation, return predictability, option implied volatility, realized volatility, variance risk premium
JEL Classification: C22, C51, C52, G12, G13, G14
Date posted: September 21, 2006 ; Last revised: December 14, 2008
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