Volatility of Volatility and Tail Risk Premiums

52 Pages Posted: 19 Oct 2013

See all articles by Yang-Ho Park

Yang-Ho Park

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2013

Abstract

This paper reports on tail risk premiums in two tail risk hedging strategies: the S&P 500 puts and the VIX calls. As a new measure of tail risk, we suggest using a model-free, risk-neutral measure of the volatility of volatility implied by a cross section of the VIX options, which we call the VVIX index. The tail risk measured by the VVIX index has forecasting power for future tail risk hedge returns. Specifically, consistent with the literature on rare disasters, an increase in the VVIX index raises the current prices of tail risk hedges and thus lowers their subsequent returns over the next three to four weeks. Furthermore, we find that volatility of volatility risk and its associated risk premium both significantly contribute to the forecasting power of the VVIX index, and that the predictability largely results from the integrated volatility of volatility rather than volatility jumps.

Keywords: Volatility of volatility, tail risk, rare disaster, option returns, risk premiums, VIX options

JEL Classification: G12, G13

Suggested Citation

Park, Yang-Ho, Volatility of Volatility and Tail Risk Premiums (August 1, 2013). FEDS Working Paper No. 2013-54. Available at SSRN: https://ssrn.com/abstract=2341734 or http://dx.doi.org/10.2139/ssrn.2341734

Yang-Ho Park (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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