Nonlinear Dynamics in Conditional Volatility

Lorenz, Friedrich; Schmedders, Karl; Schumacher, Malte

doi:10.2139/ssrn.3575458

Nonlinear Dynamics in Conditional Volatility

Proceedings of Paris December 2020 Finance Meeting EUROFIDAI - ESSEC

48 Pages Posted: 8 May 2020 Last revised: 13 Oct 2020

See all articles by Friedrich Lorenz

Friedrich Lorenz

University of Muenster - Finance Center Muenster

Malte Schumacher

University of Zurich - Department of Business Administration

Date Written: April 13, 2020

Abstract

Investors pay a substantial premium to hedge against fluctuations in volatility—the variance risk premium (VRP). The asset-pricing literature has presented numerous models with jumps in economic fundamentals to reproduce the properties and the time variation of the VRP. This paper shows that these quantitative results are almost exclusively driven by an inaccurate measure of conditional volatility. Solved accurately, conditional volatility exhibits—counterfactually—a strong procyclical pattern and the models do not deliver a sizeable VRP in response to jumps in state variables. The notion that the VRP is purely a compensation for fluctuations in macroeconomic uncertainty does not hold.

Keywords: asset pricing, conditional volatility, variance risk premium

JEL Classification: G11, G12

Suggested Citation: Suggested Citation

Lorenz, Friedrich and Schmedders, Karl and Schumacher, Malte, Nonlinear Dynamics in Conditional Volatility (April 13, 2020). Proceedings of Paris December 2020 Finance Meeting EUROFIDAI - ESSEC, Available at SSRN: https://ssrn.com/abstract=3575458 or http://dx.doi.org/10.2139/ssrn.3575458