Tail Risk Premia and Return Predictability

The variance risk premium, defined as the difference between actual and risk-neutralized expectations of the forward aggregate market variation, helps predict future market returns. Relying on new essentially model-free estimation procedure, we show that much of this predictability may be attributed to time variation in the shape of the tails and compensation demanded by investors for bearing jump tail risk. Our results are consistent with the idea that the temporal variation in the separate diffusive and jump risk components of the variance risk premium may be associated with notions of time-varying economic uncertainty and changes in risk aversion, or market fears, respectively.