Variance Discount Rates: What Drives Preferences over Variance Risk?
72 Pages Posted: 22 Jan 2021 Last revised: 24 Dec 2022
Date Written: November 12, 2020
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
Suggested Citation: Suggested Citation