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The market price of risk of the variance term structure

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  • Dotsis, George

Abstract

In this paper I examine the market price of risk of the variance term structure. To this end, the S&P 500 option implied variance term structure is used as a proxy for aggregate variance risk. Principal component analysis shows that time variation in the variance term structure over the 1996–2012 period can be explained mainly by two factors which capture changes in the level and slope. The market price of risk of each factor is estimated in the cross-section of stock returns. The slope of the variance term structure is the most significant factor in the cross-section of stocks returns and carries a negative risk premium. The slope factor has also some predictive ability over long horizon equity returns.

Suggested Citation

  • Dotsis, George, 2017. "The market price of risk of the variance term structure," Journal of Banking & Finance, Elsevier, vol. 84(C), pages 41-52.
  • Handle: RePEc:eee:jbfina:v:84:y:2017:i:c:p:41-52
    DOI: 10.1016/j.jbankfin.2015.10.008
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    Keywords

    Stochastic variance; Variance term structure; Cross-section of returns;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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