A Non-Linear Dynamic Model of the Variance Risk Premium

50 Pages Posted: 12 Mar 2012 Last revised: 3 Dec 2014

See all articles by Jiakou Wang

Jiakou Wang

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Bjorn Eraker

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 2012

Abstract

We estimate a non-linear diffusion model to capture the dynamics of the VIX index. The model is estimated under the risk neutral and the objective probability measures. The risk neutral dynamics are captured through a novel estimation method applied to futures prices. We find that non-linearity is important in capturing the time-series properties of the VIX index. In particular, we document that the VIX mean reverts more quickly from high levels than from low levels, suggesting that financial crisis regimes are less persistent than predicted by a linear model. The nonlinearity can explain the VIX risk premium outliers, especially the peak in the financial crisis in 2008.

Suggested Citation

Wang, Jiakou and Eraker, Bjorn, A Non-Linear Dynamic Model of the Variance Risk Premium (March 1, 2012). Midwest Finance Association 2013 Annual Meeting Paper. Available at SSRN: https://ssrn.com/abstract=2018689 or http://dx.doi.org/10.2139/ssrn.2018689

Jiakou Wang (Contact Author)

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States

Bjorn Eraker

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States

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