Expected Stock Returns and Variance Risk Premia

Finance and Economics (FEDS) Discussion Paper No. W 2007-11

33 Pages Posted: 17 Sep 2009

See all articles by Tim Bollerslev

Tim Bollerslev

Duke University - Finance; Duke University - Department of Economics; National Bureau of Economic Research (NBER)

Hao Zhou

Tsinghua University - PBC School of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2007

Abstract

We find that the difference between implied and realized variances, or the variance risk premium, is able to explain more than fifteen percent of the ex-post time series variation in quarterly excess returns on the market portfolio over the 1990 to 2005 sample period, with high (low) premia predicting high (low) future returns. The magnitude of the return predictability of the variance risk premium easily dominates that afforded by standard predictor variables like the P/E ratio, the dividend yield, the default spread, and the consumption-wealth ratio (CAY). Moreover, combining the variance risk premium with the P/E ratio results in an R2 for the quarterly returns of more than twenty-five percent. The results depend crucially on the use of "model-free", as opposed to standard Black-Scholes, implied variances, and realized variances constructed from high-frequency intraday, as opposed to daily, data. Our findings suggest that temporal variation in risk and risk-aversion both play an important role in determining stock market returns.

Keywords: Return Predictability, Implied Variance, Realized Variance, Equity Risk Premium, Variance Risk Premium, Time-Varying Risk Aversion

JEL Classification: G12, G14

Suggested Citation

Bollerslev, Tim and Zhou, Hao, Expected Stock Returns and Variance Risk Premia (April 1, 2007). Finance and Economics (FEDS) Discussion Paper No. W 2007-11. Available at SSRN: https://ssrn.com/abstract=1315328 or http://dx.doi.org/10.2139/ssrn.1315328

Tim Bollerslev

Duke University - Finance ( email )

Durham, NC 27708-0120
United States
919-660-1846 (Phone)
919-684-8974 (Fax)

Duke University - Department of Economics

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Hao Zhou (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China
86-10-62790655 (Phone)

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