Term Structure of Variance Risk Premium and Returns' Predictability

49 Pages Posted: 18 Jun 2015 Last revised: 22 Aug 2016

See all articles by Giacomo Bormetti

Giacomo Bormetti

University of Bologna - Department of Mathematics

Fulvio Corsi

University of Pisa - Department of Economics; City University London

Adam Majewski

Capital Fund Management

Date Written: August 18, 2016

Abstract

We derive an analytic relation between equity risk premium and the term structure of variance risk premium (VRP). Motivated by this result, we estimate the VRP term structure using a general and fully analytical discrete-time option pricing framework featuring multiple volatility components and multiple risk premia. We confirm the importance of VRP in improving option pricing performances and show the ability of multi-component GARCH models to produce realistic hump-shaped VRP term structure. We finally uncover the strong predictive power of the shape of the VRP term structure, summarized by its slope, on future stock-index returns.

Keywords: Component GARCH, variance risk premium, predictability, equity risk premium, term structure, option pricing

JEL Classification: G12, G13

Suggested Citation

Bormetti, Giacomo and Corsi, Fulvio and Majewski, Adam, Term Structure of Variance Risk Premium and Returns' Predictability (August 18, 2016). Available at SSRN: https://ssrn.com/abstract=2619278 or http://dx.doi.org/10.2139/ssrn.2619278

Giacomo Bormetti (Contact Author)

University of Bologna - Department of Mathematics ( email )

Piazza di Porta S. Donato , 5
Bologna, Bologna 40126
Italy

Fulvio Corsi

University of Pisa - Department of Economics ( email )

via Ridolfi 10
I-56100 Pisa, PI 56100
Italy

HOME PAGE: http://people.unipi.it/fulvio_corsi/

City University London ( email )

Northampton Square
London, EC1V OHB
United Kingdom

Adam Majewski

Capital Fund Management ( email )

23 rue de l'Université
Paris, 75007
France

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