Variance Discount Rates: What Drives Preferences over Variance Risk?

72 Pages Posted: 22 Jan 2021 Last revised: 24 Dec 2022

See all articles by Joren Koëter

Joren Koëter

Rotterdam School of Management, Erasmus University

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

Koëter, Joren, Variance Discount Rates: What Drives Preferences over Variance Risk? (November 12, 2020). Available at SSRN: https://ssrn.com/abstract=3728730 or http://dx.doi.org/10.2139/ssrn.3728730

Joren Koëter (Contact Author)

Rotterdam School of Management, Erasmus University ( email )

RSM Erasmus University
PO Box 1738
Rotterdam, 3062 PA
Netherlands

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