A Non-Linear Dynamic Model of the Variance Risk Premium
35 Pages Posted: 29 Apr 2012 Last revised: 3 Dec 2014
Date Written: December 1, 2014
We propose a new class of non-linear diffusion processes for modeling financial markets data. Our non-linear diffusions are obtained as transformations of affine processes. We show that asset-pricing and estimation is possible and likelihood estimation is straightforward. We estimate a non-linear diffusion model for the VIX index under both the objective measure and the risk-neutral measure where the latter is obtained from futures prices. We find evidence of significant non-linearity under both measures. We define the difference between the P and Q drift as a measure of the variance risk premium and show that it has strong predictive power for stock returns.
Keywords: VIX, variance risk premium, nonlinear model
JEL Classification: C14
Suggested Citation: Suggested Citation