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The Variance Risk Premium: Components, Term Structures, and Stock Return Predictability

39 Pages Posted: 5 Jun 2014 Last revised: 6 Apr 2016

Junye Li

ESSEC Business School

Gabriele Zinna

Bank of Italy

Date Written: March 2016

Abstract

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

Li, Junye and Zinna, Gabriele, The Variance Risk Premium: Components, Term Structures, and Stock Return Predictability (March 2016). Available at SSRN: https://ssrn.com/abstract=2445828 or http://dx.doi.org/10.2139/ssrn.2445828

Junye Li (Contact Author)

ESSEC Business School ( email )

3 Avenue Bernard Hirsch
CS 50105 CERGY
CERGY, CERGY PONTOISE CEDEX 95021
France

Gabriele Zinna

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

HOME PAGE: http://gabrielezinna.github.io/

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