Risk Premium, Variance Premium and the Maturity Structure of Uncertainty

Review of Finance (2014) 18 (1): 219-269.

44 Pages Posted: 15 Feb 2011 Last revised: 17 Dec 2016

Bruno Feunou

Bank of Canada

Jean-Sebastien Fontaine

Bank of Canada

Abderrahim Taamouti

Universidad Carlos III de Madrid

Roméo Tédongap

ESSEC Business School Paris-Singapore

Date Written: September 1, 2012

Abstract

Expected returns vary when investors face time-varying investment opportunities. In theory, structural long-run risk models (Bansal and Yaron, 2004) and no-arbitrage affine models (Duffie, Pan, and Singleton, 2000) emphasize sources of risk that are not observable to the econometrician. We show that the term structure of risk implicit in option prices can reveal these risk factors exante. Empirically, we find that the variance term structure reveals two important drivers of the bond premium, the equity premium and the variance premium, jointly. Similarly, two risk factors are sufficient to capture the predictive content of higher-order uncertainty – skewness and kurtosis – but these do not add to the predictive content of the variance factors. The predicted equity premium is counter-cyclical and our results are robust to the inclusion of other known predictors of returns. Overall, our results bode well for our ability to link risk-return trade-offs across different markets, and across horizons, within a unified theoretical framework.

Keywords: Equity Premium, Variance Premium, Risk-neutral Variance, Term Structure of Variance, Long-Run Risk

JEL Classification: G12, G13.

Suggested Citation

Feunou, Bruno and Fontaine, Jean-Sebastien and Taamouti, Abderrahim and Tédongap, Roméo, Risk Premium, Variance Premium and the Maturity Structure of Uncertainty (September 1, 2012). Review of Finance (2014) 18 (1): 219-269.. Available at SSRN: https://ssrn.com/abstract=1754669 or http://dx.doi.org/10.2139/ssrn.1754669

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)
613-782-7713 (Fax)

HOME PAGE: http://kamkui.net/

Jean-Sebastien Fontaine (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

HOME PAGE: http://www.jean-sebastienfontaine.com

Abderrahim Taamouti

Universidad Carlos III de Madrid ( email )

CL. de Madrid 126
Madrid, Madrid 28903
Spain
+34-91 6249863 (Phone)
+34-91 6249329 (Fax)

HOME PAGE: http://www.eco.uc3m.es/english/index.html

Roméo Tédongap

ESSEC Business School Paris-Singapore ( email )

Avenue Bernard Hirsch
BP 105 Cergy Cedex, 95021
France
+33134439734 (Phone)
+33134439734 (Fax)

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