Variance Trading and Market Price of Variance Risk
34 Pages Posted: 14 Oct 2011 Last revised: 4 Aug 2014
Date Written: January 1, 2014
This paper develops a new approach for variance trading. We show that the discretely-sampled realized variance can be robustly replicated under very general conditions, including when the price can jump. The replication strategy specifies the exact timing for rebalancing in the underlying. The deviations from the optimal schedule can lead to surprisingly large hedging errors.
In the empirical application, we synthesize the prices of the variance contract on S&P 500 index over the period from 01/1990 to 12/2009. We find that the market variance risk is priced, its risk premium is negative and economically very large. The variance risk premium cannot be explained by the known risk factors and option returns.
Keywords: Variance Risk, Option Valuation, Risk-Neutral Density, Stochastic Volatility
JEL Classification: G12, G13, G23
Suggested Citation: Suggested Citation