Decomposing the VIX: Implications for the Predictability of Stock Returns

The Financial Review, Forthcoming

39 Pages Posted: 14 Mar 2016 Last revised: 19 Aug 2020

See all articles by Victor Chow

Victor Chow

West Virginia University - Department of Finance

Wanjun Jiang

Guang Hua School of Management, Peking University

Bingxin Li

West Virginia University

Jingrui (Victoria) Li

Tulane University - A.B. Freeman School of Business

Date Written: January 16, 2018

Abstract

The VIX index is not only a volatility index but also a polynomial combination of all possible higher moments in market return distribution under the risk-neutral measure. This paper formulates the VIX as a linear decomposition of four fundamentally different elements: the realized variance (RV), the variance risk premium (VRP), the realized tail (RT), and the tail risk premium (TRP), respectively. Using an innovative and nonparametric tail risk measure, we find that approximately one-third of the VIX's formation is attributed to the TRP. In addition to VRP, RT and TRP are crucial components for predicting future returns on equity portfolios.

Keywords: Polynomial Variation, Quadratic Variation, Variance Risk Premium, Tail Risk Premium, Predictability

JEL Classification: C22, C51, C52, G1, G12, G13

Suggested Citation

Chow, Victor and Jiang, Wanjun and Li, Bingxin and Li, Jingrui, Decomposing the VIX: Implications for the Predictability of Stock Returns (January 16, 2018). The Financial Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2747169 or http://dx.doi.org/10.2139/ssrn.2747169

Victor Chow

West Virginia University - Department of Finance ( email )

P. O. Box 6025
Morgantown, WV 26506
United States

Wanjun Jiang

Guang Hua School of Management, Peking University ( email )

Beijing
China

Bingxin Li

West Virginia University ( email )

Morgantown, WV 26506
United States
304-293-2777 (Phone)

Jingrui Li (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

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