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What's Vol Got to Do With It

Author

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  • Itamar Drechsler

    (The Wharton School)

  • Amir Yaron

    (The Wharton School)

Abstract

Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward un- certainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents’ views of economic uncertainty and prices.

Suggested Citation

  • Itamar Drechsler & Amir Yaron, 2008. "What's Vol Got to Do With It," 2008 Meeting Papers 282, Society for Economic Dynamics.
  • Handle: RePEc:red:sed008:282
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    File URL: https://economicdynamics.org/meetpapers/2008/paper_282.pdf
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    References listed on IDEAS

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    Cited by:

    1. David Backus & Mikhail Chernov & Ian Martin, 2011. "Disasters Implied by Equity Index Options," Journal of Finance, American Finance Association, vol. 66(6), pages 1969-2012, December.
    2. Tim Bollerslev & Natalia Sizova & George Tauchen, 2011. "Volatility in Equilibrium: Asymmetries and Dynamic Dependencies," Review of Finance, European Finance Association, vol. 16(1), pages 31-80.
    3. Tim Bollerslev & George Tauchen & Hao Zhou, 2009. "Expected Stock Returns and Variance Risk Premia," Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4463-4492, November.
    4. Jessica A. Wachter, 2013. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," Journal of Finance, American Finance Association, vol. 68(3), pages 987-1035, June.

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