How informative are variance risk premium and implied volatility for Value-at-Risk prediction? International evidence

The aim of this paper is to examine the information embedded in the implied volatility index and the variance risk premium in terms of quantifying market risk for developed and emerging stock markets. The backtesting results indicate that incorporating the relative variance risk premium into the GARCH model, greatly enhances the forecasts of one-day-ahead Value-at-Risk (VaR) for a long trading position in developed markets, while the standard GARCH is the most relevant specification in capturing risk in emerging markets. Results are found to be robust against distressed financial markets and alternative measures of the variance risk premium. Moreover, the empirical evidence shows that the superior performance of these models cannot completely reduce the scope of implied volatility as a risk management tool. Including implied volatility into the GARCH model incurs substantial savings in terms of efficient regulatory capital provisions.