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Variance Swaps and Intertemporal Asset Pricing

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Abstract

This paper proposes an ICAPM in which the risk premium embedded in variance swaps is the factor mimicking portfolio for hedging exposure to changes in future investment conditions. Recent empirical evidence shows that the fears by investors to deviations from Normality in the distribution of returns are able to explain time-varying financial and macroeconomic risks in addition to being a determinant of the variance risk premium. Moreover, variance swaps hedges unfavorable changes in the stochastic investment opportunity set, and is not a redundant asset because significantly expands the efficient mean-variance frontier. Thence, we should expect the variance swap risk incremental pricing information associated with the variance risk premium, particularly at shorter horizons.

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Paper provided by Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico in its series Documentos de Trabajo del ICAE with number 2011-08.

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Length: 33 pages
Date of creation: 2011
Date of revision:
Handle: RePEc:ucm:doicae:1108

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Keywords: variance risk premium; intertemporal asset pricing;

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  1. Fousseni Chabi-Yo, 2008. "Conditioning Information and Variance Bounds on Pricing Kernels with Higher- Order Moments: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 21(1), pages 181-231, January.
  2. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  3. Michael J. Brennan & Ashley W. Wang & Yihong Xia, 2004. "Estimation and Test of a Simple Model of Intertemporal Capital Asset Pricing," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1743-1776, 08.
  4. Joost Driessen & Pascal J. Maenhout & Grigory Vilkov, 2009. "The Price of Correlation Risk: Evidence from Equity Options," Journal of Finance, American Finance Association, American Finance Association, vol. 64(3), pages 1377-1406, 06.
  5. Hahn, Jaehoon & Lee, Hangyong, 2006. "Yield Spreads as Alternative Risk Factors for Size and Book-to-Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 41(02), pages 245-269, June.
  6. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
  7. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
  8. Ralitsa Petkova, 2006. "Do the Fama-French Factors Proxy for Innovations in Predictive Variables?," Journal of Finance, American Finance Association, American Finance Association, vol. 61(2), pages 581-612, 04.
  9. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, Elsevier, vol. 5(1), pages 31-56, January.
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