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What's Vol Got to Do With It

63 Pages Posted: 20 Mar 2008 Last revised: 14 Dec 2011

Itamar Drechsler

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Amir Yaron

University of Pennsylvania -- Wharton School of Business; National Bureau of Economic Research (NBER)

Date Written: December 1, 2009

Abstract

Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents' views of economic uncertainty and prices.

Keywords: Return Predictability, Variance Premium, Long Run Risks, Stochastic Volatility, Jump Risks

JEL Classification: G12, D84, E37

Suggested Citation

Drechsler, Itamar and Yaron, Amir, What's Vol Got to Do With It (December 1, 2009). AFA 2009 San Francisco Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1081236 or http://dx.doi.org/10.2139/ssrn.1081236

Itamar Drechsler (Contact Author)

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Amir Yaron

University of Pennsylvania -- Wharton School of Business ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-1241 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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