Download this Paper Open PDF in Browser

Variance Premium, Downside Risk, and Expected Stock Returns

49 Pages Posted: 6 Nov 2017 Last revised: 27 Nov 2017

Bruno Feunou

Bank of Canada

Ricardo Lopez Aliouchkin

Syracuse University

Roméo Tédongap

ESSEC Business School

Lai Xu

Syracuse University

Date Written: November 2, 2017

Abstract

We decompose total variance into its bad and good components and measure the premia associated with their fluctuations using stock and option data from a large cross-section of fi rms. The total variance risk premium (VRP) represents the premium paid to insure against fluctuations in bad variance (called bad VRP), net of the premium received to compensate for fluctuations in good variance (called good VRP). Bad VRP provides a direct assessment of the degree to which asset downside risk may become extreme, while good VRP proxies for the degree to which asset upside potential may shrink. We find that bad VRP is important economically; in the cross-section, a one standard deviation increase is associated with an increase of up to 12% in annualized expected excess returns. Simultaneously going long stocks with high bad VRP and short stocks with low bad VRP yields an annualized risk-adjusted expected excess return of 18%. This result remains signi cant in double-sort strategies and cross-sectional regressions controlling for a host of firm characteristics and exposures to regular and downside risk factors.

Keywords: Variance Forecasting, Signed Jump Risk Premium

JEL Classification: G12

Suggested Citation

Feunou, Bruno and Lopez Aliouchkin, Ricardo and Tédongap, Roméo and Xu, Lai, Variance Premium, Downside Risk, and Expected Stock Returns (November 2, 2017). Available at SSRN: https://ssrn.com/abstract=3064263

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Ricardo Lopez Aliouchkin

Syracuse University ( email )

721 University Ave
Syracuse, NY NY 13244
United States
+13154433672 (Phone)

HOME PAGE: http://www.ricardolopezaliouchkin.com/

Roméo Tédongap (Contact Author)

ESSEC Business School ( email )

Avenue Bernard Hirsch
BP 105 Cergy Cedex, 95021
France
+33134439734 (Phone)
+33134439734 (Fax)

Lai Xu

Syracuse University ( email )

900 S. Crouse Avenue
Syracuse, NY 13244-2130
United States

Paper statistics

Downloads
105
Rank
222,409
Abstract Views
308