Department of Economics and Business Economics

Variance swap payoffs, risk premia and extreme market conditions

Publication: ResearchWorking paper

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  • rp17_21

    Final published version, 1010 KB, PDF-document

  • Jeroen V.K. Rombouts
    Jeroen V.K. RomboutsESSEC Business SchoolFrance
  • Lars Stentoft
    Lars StentoftHEC MontréalCenter for Research in Econometric Analysis of Time Series (CREATES), Department of Economics and Business, Aarhus UniversityCanada
  • Francesco Violante
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.
Original languageEnglish
Place of PublicationAarhus
PublisherInstitut for Økonomi, Aarhus Universitet
Number of pages46
StatePublished - 30 May 2017
SeriesCREATES Research Papers
Number2017-21

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