Dynamic Estimation of Volatility Risk Premia and Investor Risk Aversion from Option-Implied and Realized Volatilities
CREATES Research Paper 2007-16
48 Pages Posted: 23 Jun 2008 Last revised: 25 Sep 2009
Date Written: April 2007
This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment confirms that the procedure works well in practice. Implementing the procedure with actual S&P 500 option-implied volatilities and high-frequency five-minute-based realized volatilities indicates significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns.
Keywords: Stochastic Volatility Risk Premium, Model-Free Implied Volatility, Model-Free Realized Volatility, Black-Scholes, GMM Estimation, Return Predictability
JEL Classification: G12, G13, C51, C52
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