What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk?

58 Pages Posted: 17 Mar 2013 Last revised: 3 Feb 2016

Jianqing Fan

Princeton University - Bendheim Center for Finance

Michael B. Imerman

Lehigh University; Princeton University

Wei Dai

Princeton University - Department of Operations Research & Financial Engineering (ORFE)

Date Written: October 28, 2015

Abstract

This paper provides a data-driven analysis of the volatility risk premium, using tools from high-frequency finance and Big Data analytics. We argue that the volatility risk premium, loosely defined as the difference between realized and implied volatility, can best be understood when viewed as a systematically priced bias. We first use ultra-high-frequency transaction data on SPDRs and a novel approach for estimating integrated volatility on the frequency domain to compute realized volatility. From that we subtract the daily VIX, our measure of implied volatility, to construct a time series of the volatility risk premium. To identify the factors behind the volatility risk premium as a priced bias we decompose it into magnitude and direction. We find compelling evidence that the magnitude of the deviation of the realized volatility from implied volatility represents supply and demand imbalances in the market for hedging tail risk. It is difficult to conclusively accept the hypothesis that the direction or sign of the volatility risk premium reflects expectations about future levels of volatility. However, evidence supports the hypothesis that the sign of the volatility risk premium is indicative of gains or losses on a delta-hedged portfolio.

Keywords: volatility risk premium, integrated volatility, ultra-high-frequency data, microstructure noise, Fourier transform, tail risk, Big Data risk analytics

JEL Classification: C01, C55, C58, G12, G17

Suggested Citation

Fan, Jianqing and Imerman, Michael B. and Dai, Wei, What Does the Volatility Risk Premium Say About Liquidity Provision and Demand for Hedging Tail Risk? (October 28, 2015). Journal of Business and Economic Statistics (Forthcoming). Available at SSRN: https://ssrn.com/abstract=2234438 or http://dx.doi.org/10.2139/ssrn.2234438

Jianqing Fan

Princeton University - Bendheim Center for Finance ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States
609-258-7924 (Phone)
609-258-8551 (Fax)

HOME PAGE: http://orfe.princeton.edu/~jqfan/

Michael B. Imerman (Contact Author)

Lehigh University ( email )

Bethlehem, PA 18015
United States
610-758-6380 (Phone)

Princeton University ( email )

Sherrerd Hall
Princeton, NJ 08544
United States
609-258-1889 (Phone)

Wei Dai

Princeton University - Department of Operations Research & Financial Engineering (ORFE) ( email )

Sherrerd Hall, Charlton Street
Princeton, NJ 08544
United States

Paper statistics

Downloads
435
Rank
53,007
Abstract Views
1,763