Expected Stock Returns and Variance Risk Premia
Finance and Economics (FEDS) Discussion Paper No. W 2007-11
33 Pages Posted: 17 Sep 2009
Date Written: April 1, 2007
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: Suggested Citation