A global factor in variance risk premia and local bond pricing

Iryna Kaminska and Matt Roberts-Sklar

No 576, Bank of England working papers from Bank of England

Abstract: In a world of interconnected financial markets it is plausible that risk appetite — an important factor in asset pricing — is determined globally. By constructing an estimate of variance risk premia (VRP) for UK, US and euro-area equity markets, we are able to estimate international variance risk premia and use them to construct a proxy for global risk aversion. The impact of this time-varying risk aversion proxy on bond risk premia is then analysed within an arbitrage-free term structure model of UK interest rates, where it is introduced explicitly as a pricing factor. By linking VRP to a stochastic discount factor, we find that the risk aversion factor has significantly affected UK government bond yields. The changes in the risk aversion factor have been particularly important in the period of the 2008–09 financial crisis, with medium maturity yields being affected the most.

Keywords: Affine term structure models; option implied volatility; realized volatility; risk aversion; stochastic discount factor; variance risk premium; volatility forecasting (search for similar items in EconPapers)
JEL-codes: C22 C52 E43 G12 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2015-12-21
New Economics Papers: this item is included in nep-eec, nep-fmk, nep-mac and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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