58 Pages Posted: 2 Nov 2013 Last revised: 13 Feb 2017
Date Written: October 24, 2016
We introduce downward volatility jumps into a general non-affine modeling framework of the term structure of variance. With variance swaps and S&P 500 returns, we find that downward volatility jumps are associated with a resolution of policy uncertainty, mostly through statements from FOMC meetings and speeches of the Fed chairman. We also find that such jumps are priced with positive risk premia, which reflect the price of the "put protection" offered by the Fed. Ignoring them may lead to an incorrect interpretation of such tail events. Moreover, variance risk premia tend to be insignificant or even positive at the inception of crises. On the modeling side, we explore the structural differences and relative goodness-of-fits of factor specifications, and find that the log-volatility model with two Ornstein-Uhlenbeck factors and double-sided jumps is superior in capturing volatility dynamics and pricing variance swaps, compared to the affine model prevalent in the literature or non-affine specifications without downward jumps.
Keywords: Non-Affine Derivative Pricing Models, Log Volatility Models, Quadratic Volatility Models, Downward Volatility Jumps, Variance Swaps
JEL Classification: G12, G13
Suggested Citation: Suggested Citation
Amengual, Dante and Xiu, Dacheng, Resolution of Policy Uncertainty and Sudden Declines in Volatility (October 24, 2016). Chicago Booth Research Paper No. 13-78; Fama-Miller Working Paper . Available at SSRN: https://ssrn.com/abstract=2348137 or http://dx.doi.org/10.2139/ssrn.2348137
By Andrew Ang