Variance Discount Rates: What Drives Preferences over Variance Risk?

Abstract

I study time-variation in variance discount rates, defined as the expected returns for investing directly into stock market variance. Using a present value identity for S&P 500 variance swap prices, I document a strong term structure in the decomposition of variance swap price variation. Short-term variance swap prices mostly vary due to variation in expected stock market variance, whereas long-term variance swap prices are predominantly driven by variance discount rates. In contrast, prominent asset pricing models, which feature variance risk to capture time-variation in the equity premium, predict a flat term structure in the decomposition of variance swap price variation.

Keywords: asset pricing, derivatives, variance pricing, variance discount rates

JEL Classification: G12, G13