Inferring Volatility Dynamics and Risk Premia from the S&P 500 and VIX Markets
69 Pages Posted: 4 Jun 2016 Last revised: 2 Feb 2017
Date Written: November 17, 2016
This paper shows that the VIX market contains information that is not already contained by the S&P 500 market on the variance of the S&P 500 returns. We estimate a flexible affine model based on a joint time series of underlying indexes and option prices on both markets. We find that including VIX option prices in the model estimation allows better identification of the parameters driving the risk-neutral conditional distributions and term structure of volatility, thereby enhancing the estimation of the variance risk premium. We gain new insights on the properties of the premium's term structure and show how they can be used to form trading signals. Finally, our premium has better predictive power than the usual model-free estimate and the higher-order moments of its term structure allow improving forecasts of S&P 500 returns.
Keywords: S&P 500 and VIX joint modeling, volatility dynamics, particle filter, variance risk premium
JEL Classification: G12, G13, C58
Suggested Citation: Suggested Citation