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A global factor in variance risk premia and local bond pricing

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  • Kaminska, Iryna

    () (Bank of England)

  • Roberts-Sklar, Matt

    () (Bank of England)

Abstract

In a world of interconnected financial markets it is plausible that risk appetite — an important factor in asset pricing — is determined globally. By constructing an estimate of variance risk premia (VRP) for UK, US and euro-area equity markets, we are able to estimate international variance risk premia and use them to construct a proxy for global risk aversion. The impact of this time-varying risk aversion proxy on bond risk premia is then analysed within an arbitrage-free term structure model of UK interest rates, where it is introduced explicitly as a pricing factor. By linking VRP to a stochastic discount factor, we find that the risk aversion factor has significantly affected UK government bond yields. The changes in the risk aversion factor have been particularly important in the period of the 2008–09 financial crisis, with medium maturity yields being affected the most.

Suggested Citation

  • Kaminska, Iryna & Roberts-Sklar, Matt, 2015. "A global factor in variance risk premia and local bond pricing," Bank of England working papers 576, Bank of England.
  • Handle: RePEc:boe:boeewp:0576
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    More about this item

    Keywords

    Affine term structure models; option implied volatility; realized volatility; risk aversion; stochastic discount factor; variance risk premium; volatility forecasting;

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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