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A Theory of Volatility Spreads

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  • Gurdip Bakshi

    ()
    (Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, Maryland 20742)

  • Dilip Madan

    ()
    (Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, Maryland 20742)

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    Abstract

    This study formalizes the departure between risk-neutral and physical index return volatilities, termed volatility spreads. Theoretically, the departure between risk-neutral and physical index volatility is connected to the higher-order physical return moments and the parameters of the pricing kernel process. This theory predicts positive volatility spreads when investors are risk averse, and when the physical index distribution is negatively skewed and leptokurtic. Our empirical evidence is supportive of the theoretical implications of risk aversion, exposure to tail events, and fatter left-tails of the physical index distribution in markets where volatility is traded.

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    File URL: http://dx.doi.org/10.1287/mnsc.1060.0579
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    Bibliographic Info

    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 52 (2006)
    Issue (Month): 12 (December)
    Pages: 1945-1956

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    Handle: RePEc:inm:ormnsc:v:52:y:2006:i:12:p:1945-1956

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    Related research

    Keywords: risk aversion; physical return moments; pricing kernel; risk-neutral volatility; volatility spreads; spanning risk-neutral moments;

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