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The Pricing of Tail Risk and the Equity Premium: Evidence From International Option Markets

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  • Torben G. Andersen
  • Nicola Fusari, The Johns Hopkins University Carey Business School
  • ,
  • Viktor Todorov, Kellogg School of Management Northwestern University

We explore the pricing of tail risk as manifest in index options across international equity markets. The risk premium associated with negative tail events displays persistent shifts, unrelated to volatility. This tail risk premium is a potent predictor of future returns for all the indices, while the option-implied volatility only forecasts the future return variation. Hence, compensation for negative jump risk is the primary driver of the equity premium, whereas the reward for pure diffusive variance risk is unrelated to future equity returns. We also document pronounced commonalities, suggesting a high degree of integration among the major global equity markets. KEY WORDS: Equity risk premium; International option markets; Predictability; Tail risk; Variance risk premium.

Original languageEnglish
JournalJournal of Business and Economic Statistics
Volume38
Issue3
Pages (from-to)662-678
Number of pages17
ISSN0735-0015
DOIs
Publication statusPublished - 2 Jul 2020
Externally publishedYes

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