The Variance Risk Premium: Components, Term Structures, and Stock Return Predictability
39 Pages Posted: 5 Jun 2014 Last revised: 6 Apr 2016
Date Written: March 2016
This paper examines the properties of the variance risk premium (VRP). We propose a flexible asset pricing model that captures co-jumps in prices and volatility, and self-exciting jump clustering. We estimate the model on equity returns and variance swap rates at different horizons. The total VRP is negative and has a downward-sloping term structure, while its jump component displays an upward-sloping term structure. The abrupt and persistent response of the short-term jump VRP to extreme events makes this specific premium a proxy for investors' fear of a market crash. Furthermore, the use of the VRP level and slope, and of its components, helps improve the short-run predictability of equity excess returns.
Keywords: Self-Exciting Jumps, Variance Risk Premia, Extreme Downside Events, Investors' Fear, Stock Return Predictability, Particle Filter.
JEL Classification: C11, C13, G12, G13
Suggested Citation: Suggested Citation