VIX Decomposed Tail Risk Premia and the Tail Risk Factor

60 Pages Posted: 14 Mar 2016 Last revised: 16 Jan 2018

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

Victoria Li

Tulane University - A.B. Freeman School of Business

Date Written: January 16, 2018

Abstract

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

Suggested Citation

Chow, Victor and Jiang, Wanjun and Li, Bingxin and Li, Jingrui, VIX Decomposed Tail Risk Premia and the Tail Risk Factor (January 16, 2018). 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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