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Variance swap payoffs, risk premia and extreme market conditions

Author

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  • Jeroen V.K. Rombouts

    () (ESSEC Business School)

  • Lars Stentoft

    () (University of Western Ontario)

  • Francesco Violante

    () (Sapienza Universitá di Roma)

Abstract

This paper estimates the Variance Risk Premium (VRP) directly from synthetic variance swap payoffs. Since variance swap payoffs are highly volatile, we extract the VRP by using signal extraction techniques based on a state-space representation of our model in combination with a simple economic constraint. Our approach, only requiring option implied volatilities and daily returns for the underlying, 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.

Suggested Citation

  • Jeroen V.K. Rombouts & Lars Stentoft & Francesco Violante, 2017. "Variance swap payoffs, risk premia and extreme market conditions," CREATES Research Papers 2017-21, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2017-21
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    References listed on IDEAS

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    More about this item

    Keywords

    Variance risk premium; Variance swaps; Return predictability; Factor Model; Kalman filter; CAPM;

    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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