Term Structure of Variance Risk Premium and Returns' Predictability
49 Pages Posted: 18 Jun 2015 Last revised: 22 Aug 2016
Date Written: August 18, 2016
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
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