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Market Price of Variance Risk and Performance of Hedge Funds

50 Pages Posted: 8 Nov 2005  

Oleg Bondarenko

University of Illinois at Chicago - Department of Finance

Date Written: March 2004

Abstract

This paper implements a model-free approach to measure the market price of the variance risk. In this approach, the value of the variance contract is estimated from prices of traded options. We find that the variance risk is priced, its risk premium is negative and economically very large. In the application to hedge funds, we argue that the variance return is a key determinant in explaining performance of hedge funds. Most hedge funds exhibit negative exposure to the variance return, implying that they routinely "sell" the variance risk. The variance risk factor accounts for a considerable portion of hedge fund historical returns.

Keywords: Variance risk, option valuation, risk-neutral density, stochastic volatility, hedge funds

JEL Classification: G12, G13, G23

Suggested Citation

Bondarenko, Oleg, Market Price of Variance Risk and Performance of Hedge Funds (March 2004). AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=542182 or http://dx.doi.org/10.2139/ssrn.542182

Oleg Bondarenko (Contact Author)

University of Illinois at Chicago - Department of Finance ( email )

2431 University Hall (UH)
601 S. Morgan Street
Chicago, IL 60607-7124
United States
(312) 996-2362 (Phone)
(312) 413-7948 (Fax)

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