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Downside Variance Risk Premium

Author

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  • Bruno Feunou
  • Mohammad R Jahan-Parvar
  • Cédric Okou

Abstract

We propose a new decomposition of the variance risk premium (VRP) in terms of upside and downside VRPs. These components reflect market compensation for changes in good and bad uncertainties. Empirically, we establish that the downside VRP is the main component of the VRP. We find a positive and significant link between the downside VRP and the equity premium, and a negative but statistically insignificant link between the upside VRP and the equity premium. The opposite relationships between these two components and the equity premium explains the stronger link found between the downside VRP and the equity premium compared with the well-established relationship between VRP and the equity premium. A simple equilibrium consumption-based asset pricing model, fitted to the U.S. data, supports our decomposition.

Suggested Citation

  • Bruno Feunou & Mohammad R Jahan-Parvar & Cédric Okou, 2018. "Downside Variance Risk Premium," Journal of Financial Econometrics, Oxford University Press, vol. 16(3), pages 341-383.
    • Handle: RePEc:oup:jfinec:v:16:y:2018:i:3:p:341-383.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbx020
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    More about this item

    Keywords

    downside and upside variance risk premium; realized volatility; risk-neutral volatility; skewness risk premium;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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