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A Non-Linear Dynamic Model of the Variance Risk Premium

35 Pages Posted: 29 Apr 2012 Last revised: 3 Dec 2014

Bjorn Eraker

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

Jiakou Wang

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

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2014

Abstract

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

Eraker, Bjorn and Wang, Jiakou, A Non-Linear Dynamic Model of the Variance Risk Premium (December 1, 2014). Journal of Econometrics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2047140 or http://dx.doi.org/10.2139/ssrn.2047140

Bjorn Eraker

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

975 University Avenue
Madison, WI 53706
United States

Jiakou Wang (Contact Author)

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

975 University Avenue
Madison, WI 53706
United States

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