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Variance swap payoffs, risk premia and extreme market conditions

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  • Rombouts, Jeroen V.K.
  • Stentoft, Lars
  • Violante, Francesco

Abstract

The variance risk premium (VRP) is estimated directly from synthetic variance swap payoffs. Since variance swap payoffs are highly volatile, the VRP is extracted by using signal extraction techniques based on a state-space representation of the model in combination with a simple economic constraint. The proposed approach, only requiring option implied volatilities and daily returns for the underlying asset, provides measurement error free estimates of the part of the VRP related to normal market conditions, and allows constructing variables indicating agents’ expectations under extreme market conditions. The latter variables and the VRP generate different return predictability on the major US indices. A factor model is proposed to extract a market VRP which turns out to be priced when considering Fama and French portfolios.

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  • Rombouts, Jeroen V.K. & Stentoft, Lars & Violante, Francesco, 2020. "Variance swap payoffs, risk premia and extreme market conditions," Econometrics and Statistics, Elsevier, vol. 13(C), pages 106-124.
  • Handle: RePEc:eee:ecosta:v:13:y:2020:i:c:p:106-124
    DOI: 10.1016/j.ecosta.2019.05.003
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    Cited by:

    1. Wilms, Ines & Rombouts, Jeroen & Croux, Christophe, 2021. "Multivariate volatility forecasts for stock market indices," International Journal of Forecasting, Elsevier, vol. 37(2), pages 484-499.

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    More about this item

    Keywords

    Variance risk premium; Variance swaps; Return predictability; Factor model; Kalman filter; CAPM;
    All these keywords.

    JEL classification:

    • C12 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Hypothesis Testing: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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