Variance Risk Premium and Expected Returns in Bull and Bear Markets

Abstract

The variance risk premium is a critical risk factor to predict expected returns. However, many studies indicate that expected returns depend strongly on the state of the economy. In this paper, we wish to determine whether the predictive power of the variance risk premium differs across market states. In our empirical results, we find that the predicted return horizons in bear markets are shorter than those in bull markets. Moreover, compared with that in a bull market state, the predictive ability of the variance risk premium diminishes more rapidly when the horizon period is lengthened in a bear market state.

Keywords: Variance risk premium, Return predictability, State dependence, High-frequency data