Variance Risk Premia, Asset Predictability Puzzles, and Macroeconomic Uncertainty

Abstract

This paper presents predictability evidence of the implied-expected variance difference, or variance risk premium, for financial market risk premia: (1) the variance difference measure predicts a positive risk premium across equity, bond, currency, and credit markets; (2) such a short-run forecastability peaks at one month horizon and dies out as horizon rises; (3) the short-run predictability is complementary to that of the standard predictor variables — P/E ratio, forward rate, interest differential, and short rate. These findings are justifiable by a general equilibrium model that incorporates stochastic economic uncertainty and recursive utility function. Within such a framework, the negative volatility risk premium implied from option prices is internally consistent with the positive variance risk premium embedded in underlying assets.

Keywords: Macroeconomic uncertainty, asset return predictability, variance risk premia, recursive utility function.

JEL Classification: G12, G13, G14