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Variance Premium and Implied Volatility in a Low-Liquidity Option Market

38 Pages Posted: 11 Apr 2015 Last revised: 13 Jun 2015

Eduardo Astorino

University of Sao Paulo (USP)

Fernando Chague

Getulio Vargas Foundation (FGV) - Sao Paulo School of Economics

Bruno Giovannetti

Getulio Vargas Foundation (FGV) - Sao Paulo School of Economics

Marcos E Silva

University of Sao Paulo (USP) - Department of Economics)

Date Written: June 12, 2015

Abstract

We propose an implied volatility index for Brazil that we name "IVol-BR". The index is based on daily market prices of options over IBOVESPA -- an option market with relatively low liquidity and few option strikes. Our methodology combines standard international methodology used in high-liquidity markets with adjustments that take into account the low liquidity in Brazilian option markets. We then do a number of empirical tests to validate the IVol-BR. First, we show that the IVol-BR has significant predictive power over future volatility of equity returns not contained in traditional volatility forecasting variables. Second, we decompose the squared IVol-BR into (i) the expected variance of stock returns and (ii) the equity variance premium. This decomposition is of interest since the equity variance premium directly relates to the representative investor risk aversion. Finally, assuming Bollerslev et al. (2009) functional form, we produce a time-varying risk aversion measure for the Brazilian investor. We empirically show that risk aversion is positively related to expected returns, as theory suggests.

Keywords: IVol-BR, Variance Risk Premium, Risk-aversion

JEL Classification: G12, G13, G17

Suggested Citation

Astorino, Eduardo and Chague, Fernando and Giovannetti, Bruno and Silva, Marcos E, Variance Premium and Implied Volatility in a Low-Liquidity Option Market (June 12, 2015). Available at SSRN: https://ssrn.com/abstract=2592650 or http://dx.doi.org/10.2139/ssrn.2592650

Eduardo Astorino

University of Sao Paulo (USP) ( email )

Rua Luciano Gualberto, 315
São Paulo, São Paulo 14800-901
Brazil

Fernando Chague (Contact Author)

Getulio Vargas Foundation (FGV) - Sao Paulo School of Economics ( email )

Rua Itapeva 474 s.1202
São Paulo, São Paulo 01332-000
Brazil

Bruno Giovannetti

Getulio Vargas Foundation (FGV) - Sao Paulo School of Economics ( email )

Rua Itapeva, 474, 10o andar
Sao Paulo, Sao Paulo 01332000
Brazil

Marcos Eugenio da Silva

University of Sao Paulo (USP) - Department of Economics) ( email )

Rua Luciano Gualberto, 315
São Paulo, São Paulo 14800-901
Brazil

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