Variance Risk Premia
44 Pages Posted: 17 Aug 2004 Last revised: 25 Oct 2007
Date Written: October 24, 2007
We propose a direct and robust method for quantifying the variance risk premium on financial assets. We theoretically and numerically show that the risk-neutral expected value of the return variance, also known as the variance swap rate, is well approximated by the value of a particular portfolio of options. Ignoring the small approximation error, the difference between the realized variance and this synthetic variance swap rate quantifies the variance risk premium. Using a large options data set, we synthesize variance swap rates and investigate the historical behavior of variance risk premia on five stock indexes and 35 individual stocks.
Keywords: Stochastic volatility, variance risk premia, variance swap, volatility swap, option pricing, expectation hypothesis
JEL Classification: G10, G12, G13, C51
Suggested Citation: Suggested Citation