An Asset Pricing Theory of Volatility Tail Behavior

37 Pages Posted: 15 Mar 2011

See all articles by Gurdip Bakshi

Gurdip Bakshi

Temple University - Fox School of Business and Management; Fox School of Business

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

George Panayotov

Hong Kong University of Science & Technology (HKUST)

Date Written: October 6, 2010

Abstract

We contrast two different asset pricing models, where the pricing kernel either (i) increases in the volatility dimension, reflecting investors’ aversion to volatility, or (ii) could be non-monotonic in volatility, reflecting heterogeneity in investors’ beliefs. The two models yield opposite predictions about volatility tail behavior, whereby the model with heterogeneity in beliefs implies that expected returns of puts on volatility could be increasing in strike. Our empirical examination appears to suggest that the model with heterogeneity in beliefs is better suited to mimic the data counterparts in the left tail of the volatility distribution, both qualitatively and quantitatively.

Keywords: Traded Volatility, VIX Option Returns, Tails of Pricing and Physical Distributions, Heterogeneity

JEL Classification: G10, G11, G12, G13, C5, D24, D84

Suggested Citation

Bakshi, Gurdip S. and Madan, Dilip B. and Panayotov, George, An Asset Pricing Theory of Volatility Tail Behavior (October 6, 2010). Available at SSRN: https://ssrn.com/abstract=1785923 or http://dx.doi.org/10.2139/ssrn.1785923

Gurdip S. Bakshi

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

George Panayotov (Contact Author)

Hong Kong University of Science & Technology (HKUST) ( email )

Clearwater Bay
Kowloon, 999999
Hong Kong
852-2358-5049 (Phone)
852-2358-1749 (Fax)

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