Downside Variance Risk Premium*

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. We thank James Pinnington for research assistance. We also thank Bryan Kelly and Seth Pruitt for sharing their cross-sectional book-to-market index data. Terms of use: Documents in EconStor mayiii AbstractWe decompose the variance risk premium into upside and downside variance risk premia. These components reflect market compensation for changes in good and bad uncertainties. Their difference is a measure of the skewness risk premium (SRP), which captures asymmetric views on favorable versus undesirable risks. Empirically, we establish that the downside variance risk premium (DVRP) is the main component of the variance risk premium. We find a positive and significant link between the DVRP and the equity premium, and a negative and significant relation between the SRP and the equity premium. A simple equilibrium consumption-based asset pricing model supports our decomposition. JEL classification: G, G1, G12 Bank classification: Asset pricing RésuméNous décomposons la prime de risque de la variance en primes de risque à la hausse et à la baisse. Ces composantes reflètent la rémunération, par le marché, des risques liés aux variations de la « bonne » et de la « mauvaise » incertitude. La différence entre les deux représente une mesure de la prime de risque d'asymétrie, laquelle rend compte de l'asymétrie des opinions au sujet des risques favorables ou défavorables. Nous déterminons de façon empirique que la prime de risque de la variance à la baisse est le principal élément de la prime de risque de la variance. Nous constatons qu'il existe une relation positive significative entre la prime de risque de la variance à la baisse et la prime de risque sur actions, et une relation négative significative entre la prime de risque d'asymétrie et la prime de risque sur actions. Un modèle simple d'équilibre des actifs fondé sur la consommation étaye notre décomposition. Classification JEL : G, G1, G12 Classification de la Banque : Évaluation des actifs iv Non-Technical SummaryThe proper assessment of risk is of paramount importance to investment decisions, given the basic tradeoff between risk and reward. The variance risk premium (VRP) is a measure of risk compensation used by investors and policy-makers to gauge investors' sentiments on uncertainty. The VRP is the difference between the forward-looking market variance implied by option prices and the actual variance realized over time. Since option-implied (risk-neutral) variance is, on average, higher than realized...

Good Volatility, Bad Volatility, and Option Pricing

“…Thus, the joint estimation results for the GSARV and CGSARV specifications are consistent with the intuition that investors dislike downside uncertainty and demand a positive premium as compensation for bearing that risk, whereas they find upside uncertainty desirable and are willing to pay (negative premium) for exposure to such risk. A typical investor's asymmetric behavior toward good versus bad uncertainty is in line with the empirical regularities documented in recent works, such as those by Feunou et al (2018) and Feunou, Jahan-Parvar, and Tédongap (2013), among others. Moreover, the joint estimation results for the GSARV and CGSARV (ω ≡ ω u = ω d ) models are close, which suggests that the wedge between upside and downside conditional volatilities (h u,t − h d,t ) is the main driver of the conditional skewness in our option valuation framework.…”

“…This decomposition of the realized variance into its up and down components is used by Patton and Sheppard (2015) to assess the information content and the predictive ability of signed squared jumps. In a recent study, Feunou, Jahan-Parvar, and Okou (2018) investigate the asymmetric behavior of investors towards good versus bad uncertainty by analyzing the premia related to upside and downside realized variances. Moreover, the difference between realized upside and downside variance, also known as the signed jump variation, can be perceived as a measure of (realized) skewness.…”

“…This difference plays a pivotal role in the determination of the variance risk premium. Building on the intuition that investors like good uncertainty (because it increases the potential of substantial gains) but dislike bad uncertainty (as it increases the likelihood of severe losses), Feunou et al (2018) have documented that the premium on the downside variance is positive VRP d t > 0 , whereas its upside counterpart is negative VRP u t < 0 . These empirical regularities are met in our model if d > 0 and u < 0, thus implying economically sound restrictions, that is:…”

Inflation Dynamics during the Financial Crisis

“…Their liquidity unconstrained counterparts, by contrast, cut prices during this period, a move consistent with the standard pricing models and the New Keynesian paradigm. 4 To rationalize the fact that firms' balance sheet positions influenced their pricing behavior during the financial crisis, we incorporate the theoretical insights of Chevalier and Scharfstein (1996) into a tractable general equilibrium model, in which monopolistically competitive firms face costly price adjustment, while setting prices to actively manage current versus future expected demand. We do so in the context of the deep habits framework formulated by Ravn, Schmitt-Grohe, and Uribe (2006), which we augment with a financial distortion, namely, costly external equity finance.…”

Predicting the Equity Market with Option Implied Variables

“…We follow Andersen & Bondarenko (2010), Andersen et al (2015) and Feunou et al (2015) and decompose the total variance risk premium into the downside and upside components. The results show that the upside and downside variance risk premium also pass both tests by providing evidence for significantly predicting excess returns and variance in-sample, and in adding economic value in a timing strategy.…”