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Jump-Diffusion Long-Run Risks Models, Variance Risk Premium and Volatility Dynamics

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  • Jianjian Jin

Abstract

This paper calibrates a class of jump-diffusion long-run risks (LRR) models to quantify how well they can jointly explain the equity risk premium and the variance risk premium in the U.S. financial markets, and whether they can generate realistic dynamics of risk-neutral and realized volatilities. I provide evidence that the jump risk in volatility of long run consumption growth is a key component of the equity risk premium and the variance risk premium in financial markets. Moreover, I find that matching the VIX dynamics during the calibration process is crucial when comparing different jump channels. Specifically, a jump-in-growth LRR model generates a good fit of the average variance risk premium, but a poor fit of the dynamics of the VIX or realized stock volatility. In contrast, a jump-in-volatility LRR model generates a smaller variance risk premium but better fits the VIX and the realized stock volatility dynamics. Finally, jump-in-volatility models generate predictability of returns by the variance risk premium that is more consistent with the data.

Suggested Citation

  • Jianjian Jin, 2013. "Jump-Diffusion Long-Run Risks Models, Variance Risk Premium and Volatility Dynamics," Staff Working Papers 13-12, Bank of Canada.
  • Handle: RePEc:bca:bocawp:13-12
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    More about this item

    Keywords

    Asset Pricing; Economic models;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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