Variance Risk Premium Components and International Stock Return Predictability

Abstract

We document and explain the distinct dynamics and international predictability patterns of U.S. downside and upside variance risk premiums (DVP and UVP, respectively). We find that DVP, the compensation for bearing downside variance risk, is positive and countercyclical, whereas UVP is borderline positive with often negative spikes. Acknowledging for asymmetry in variance premium significantly improves its international stock return predictability. To rationalize our findings, we solve a dynamic asset pricing model featuring asymmetric non-Gaussian shocks and partial integration. We find that DVP is mostly driven by risk aversion, whereas UVP loads negatively on downside economic uncertainty. Moreover, DVP (UVP) transmits to international markets through financial (economic) integration.

Keywords: Downside variance risk premium, Upside variance risk premium, International stock markets, Asymmetric state variables, Stock return predictability

JEL Classification: F36, G12, G13, G15