The VIX, the Variance Premium and Stock Market Volatility

Abstract

We decompose the squared VIX index, derived from US S&P500 options prices, into the conditional variance of stock returns and the equity variance premium. We evaluate a plethora of state-of-the-art volatility forecasting models to produce an accurate measure of the conditional variance. We then examine the predictive power of the VIX and its two components for stock market returns, economic activity and financial instability. The variance premium predicts stock returns while the conditional stock market variance predicts economic activity and has a relatively higher predictive power for financial instability than does the variance premium.

Keywords: option implied volatility, realized volatility, VIX, variance risk premium, risk aversion, stock return predictability, risk-return trade-off, economic uncertainty, financial instability

JEL Classification: C22, C52, G12, E32