Resolution of Policy Uncertainty and Sudden Declines in Volatility

Abstract

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 Federal Reserve's chairman. Ignoring such jumps may lead to an incorrect interpretation of the tail events, and hence biased estimates of variance risk premia. On the modeling side, we explore the structural differences and relative goodness-of-fits of factor specifications. We find that log-volatility models with at least one Ornstein-Uhlenbeck factor and double-sided jumps are 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