VIX Decomposition, the Price of Fear and Stock Return Predictability

53 Pages Posted: 14 Mar 2016 Last revised: 6 Jan 2017

Victor Chow

West Virginia University

Wanjun Jiang

Guang Hua School of Management, Peking University

Jingrui Li

West Virginia University

Date Written: December 30, 2016

Abstract

The VIX is not just a volatility index but a fear gauge. We formalize this market perception with a linear decomposition of the VIX that consists with four fundamentally different elements: the realized variance (RV), the variance risk premium (VRP), the realized tail (RT), and the tail risk premium (TRP), respectively. The VRP compensates the anticipated (normal) market volatility, and the TRP prices the fear of potentially (unusual) large market movements. Empirically, approximate 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: Variance Risk Premium, Tail Risk Premium, Quadratic Variation, Polynomial Variation, Realized Variance, Realized Tail.

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

Suggested Citation

Chow, Victor and Jiang, Wanjun and Li, Jingrui, VIX Decomposition, the Price of Fear and Stock Return Predictability (December 30, 2016). Available at SSRN: https://ssrn.com/abstract=2747169

Victor Chow (Contact Author)

West Virginia University ( email )

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

Wanjun Jiang

Guang Hua School of Management, Peking University ( email )

Beijing
China

Jingrui Li

West Virginia University ( email )

PO Box 6025
Morgantown, WV 26506
United States

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