Up- and Downside Variance Risk Premia in Global Equity Markets

Abstract

This paper provides novel insights into the dynamic properties of variance and semivariance premia. Considering nine international stock market indices, we find consistent evidence of significantly negative total and downside (semi)variance premia of around -15 bps per month. These premia almost exclusively compensate investors for the risk of extreme negative returns. We also document pronounced downside semivariance premia for longer times to maturity, while the term structure of the total variance premium is upward sloping for all of the considered indices. The slope is driven by upside semivariance premia which are positive over long horizons. They can only be negative in adverse states, characterized by high uncertainty and high risk aversion. We show that a general equilibrium model featuring external habit formation and “bad environment-good environment” dynamics for consumption and dividends can explain many of these stylized facts and highlight the economic mechanisms.

Keywords: variance risk premium, semivariance, semimoment, derivatives

JEL Classification: C32, G12, G15