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Downside Variance Risk Premium

Author

Listed:
  • Feunou, Bruno

    (Bank of Canada)

  • Jahan-Parvar, Mohammad

    (Board of Governors of the Federal Reserve System (U.S.))

  • Okou, Cedric

    (UQAM)

Abstract

We propose a new decomposition of the variance risk premium in terms of upside and downside variance risk premia. The difference between upside and downside variance risk premia is a measure of skewness risk premium. We establish that the downside variance risk premium is the main component of the variance risk premium, and that the skewness risk premium is a priced factor with significant prediction power for aggregate excess returns. Our empirical investigation highlights the positive and significant link between the downside variance risk premium and the equity premium, as well as a positive and significant relation between the skewness risk premium and the equity premium. Finally, we document the fact that the skewness risk premium fills the time gap between one quarter ahead predictability, delivered by the variance risk premium as a short term predictor of excess returns and traditional long term predictors such as price-dividend or price-earning ratios. Our resul ts are supported by a simple equilibrium consumption-based asset pricing model.

Suggested Citation

  • Feunou, Bruno & Jahan-Parvar, Mohammad & Okou, Cedric, 2015. "Downside Variance Risk Premium," Finance and Economics Discussion Series 2015-20, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2015-20
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    File URL: http://dx.doi.org/10.17016/FEDS.2015.020
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    Cited by:

    1. Deepa Dhume Datta & Juan M. Londono & Bo Sun & Daniel O. Beltran & Thiago Revil T. Ferreira & Matteo Iacoviello & Mohammad Jahan-Parvar & Canlin Li & Marius del Giudice Rodriguez & John H. Rogers, 2017. "Taxonomy of Global Risk, Uncertainty, and Volatility Measures," International Finance Discussion Papers 1216, Board of Governors of the Federal Reserve System (U.S.).
    2. Bruno Feunou & Cédric Okou, 2017. "Good Volatility, Bad Volatility and Option Pricing," Staff Working Papers 17-52, Bank of Canada.
    3. Hattori, Masazumi & Shim, Ilhyock & Sugihara, Yoshihiko, 2016. "Volatility Contagion across the Equity Markets of Developed and Emerging Market Economies," ADBI Working Papers 590, Asian Development Bank Institute.
    4. Prokopczuk, Marcel & Tharann, Björn & Wese Simen, Chardin, 2017. "Predicting the Equity Market with Option Implied Variables," Hannover Economic Papers (HEP) dp-619, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    5. Bruno Feunou & Ricardo Lopez Aliouchkin & Roméo Tedongap & Lai Xi, 2017. "Variance Premium, Downside Risk and Expected Stock Returns," Staff Working Papers 17-58, Bank of Canada.
    6. Reinhard Ellwanger, 2017. "On the Tail Risk Premium in the Oil Market," Staff Working Papers 17-46, Bank of Canada.

    More about this item

    Keywords

    Downside variance risk premium; realized volatility; risk-neutral volatility; skewness risk premium; upside variance risk premium;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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