VIX Decomposed Tail Risk Premia and the Tail Risk Factor
60 Pages Posted: 14 Mar 2016 Last revised: 16 Jan 2018
Date Written: January 16, 2018
This paper estimates equity tail risk premia (TRP) by decomposing the squared VIX index into four fundamentally different elements: the tail risk premium (TRP), the realized tail (RT), the variance risk premium (VRP) and the realized variance (RV), respectively. Empirically, approximate one-third of the VIX variation is attributed to the TRP. In addition to VRP, RT and TRP are crucial components for predicting future returns on equity portfolios. Applying this tail risk premia estimation methodology to individual stocks, we construct a tail risk factor, PMN, using mimicking portfolios sorted by individual stock tail risk premium. The results of Fama-Macbeth (1973) two pass regression show that the PMN factor provides additional information beyond market, size and value factors and is able to explain momentum, investment, and operating profitability factors. This indicates that the tail risk factor captures important common variation in cross-section of stock returns, especially when return distribution deviates from traditional mean-variance framework.
Keywords: Tail Risk, Jumps, Risk Premium, Asset Pricing Factor
JEL Classification: C22, C51, C52, G1, G12, G13
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