Variance Premium, Downside Risk, and Expected Stock Returns

47 Pages Posted: 4 Jun 2018

See all articles by Bruno Feunou

Bruno Feunou

Bank of Canada

Ricardo Lopez Aliouchkin

Syracuse University - Whitman School of Management

Roméo Tédongap

ESSEC Business School

Lai Xu

Syracuse University

Date Written: November 1, 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 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 13% in annualized expected excess returns. Simultaneously going long on stocks with high bad VRP and short on stocks with low bad VRP yields an annualized risk-adjusted expected excess return of 18%.

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 1, 2017). Paris December 2018 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=3189810 or http://dx.doi.org/10.2139/ssrn.3189810

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 (Contact Author)

Syracuse University - Whitman School of Management ( email )

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

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

Roméo Tédongap

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

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