Variance Discount Rates: What Drives Preferences over Variance Risk?
64 Pages Posted: 22 Jan 2021
Date Written: November 12, 2020
Abstract
I study time-variation in variance discount rates, defined as the expected returns for investing in variance risk. I show that variance discount rates drive a significant fraction of the variation in prices of S&P 500 variance swaps. This analysis offers important insights into preferences of investors over variance risk. I decompose variation in prices into variation due to variance expectations and variation due to variance discount rates. Variance expectations drive most of the variation in short-term variance swaps, whereas variance discount rates drive most of the variation in long-term variance swaps. I show that prominent asset pricing models, in which variation in the equity premium originates from variation in variance risk, have profoundly different predictions regarding the behavior of variance discount rates. None of the models analyzed are able to match the empirical properties of variance discount rates.
Keywords: asset pricing, derivatives, variance pricing, variance discount rates
JEL Classification: G12, G13
Suggested Citation: Suggested Citation
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