Department of Economics and Business Economics

Variance swap payoffs, risk premia and extreme market conditions

Research output: Contribution to journal/Conference contribution in journal/Contribution to newspaperJournal articleResearchpeer-review

The variance risk premium (VRP) is estimated directly from synthetic variance swap payoffs. Since variance swap payoffs are highly volatile, the VRP is extracted by using signal extraction techniques based on a state-space representation of the model in combination with a simple economic constraint. The proposed approach, only requiring option implied volatilities and daily returns for the underlying asset, 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
JournalEconometrics and Statistics
Volume13
Pages (from-to)106-124
Number of pages19
ISSN2468-0389
DOIs
Publication statusPublished - 2020
Externally publishedYes

    Research areas

  • CAPM, Factor model, Kalman filter, Return predictability, Variance risk premium, Variance swaps

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