The Market Price of Risk of the Variance Term Structure

Abstract

In this paper I examine the market price of risk of the variance term structure. To this end, the S&P 500 VIX variance term structure is used as a proxy for aggregate variance risk. Principal component analysis shows that time variation in the variance term structure over the 1992-2009 period can be explained mainly by two factors, which capture changes in the level and slope. The market price of risk of each factor is estimated in the cross-section of asset returns. I find that both factors have a negative market price of risk. The most important factor in the cross-section is the slope which also predicts changes in market excess returns over annual horizons. A model with the market return and the two variance factors has similar performance to the Fama-French model in pricing size and book-to-market sorted portfolios.

Keywords: stochastic volatility, volatility term structure, cross-section of returns

JEL Classification: G10, G12