Variance Premium, Downside Risk, and Expected Stock Returns
49 Pages Posted: 6 Nov 2017 Last revised: 27 Nov 2017
Date Written: November 2, 2017
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 firms. 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 signicant 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: Suggested Citation