A Theory of Volatility Spreads

Gurdip Bakshi () and Dilip Madan ()
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Gurdip Bakshi: Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, Maryland 20742
Dilip Madan: Department of Finance, Robert H. Smith School of Business, University of Maryland, College Park, Maryland 20742

Management Science, 2006, vol. 52, issue 12, 1945-1956

Abstract: This study formalizes the departure between risk-neutral and physical index return volatilities, termed volatility spreads. Theoretically, the departure between risk-neutral and physical index volatility is connected to the higher-order physical return moments and the parameters of the pricing kernel process. This theory predicts positive volatility spreads when investors are risk averse, and when the physical index distribution is negatively skewed and leptokurtic. Our empirical evidence is supportive of the theoretical implications of risk aversion, exposure to tail events, and fatter left-tails of the physical index distribution in markets where volatility is traded.

Keywords: risk aversion; physical return moments; pricing kernel; risk-neutral volatility; volatility spreads; spanning risk-neutral moments (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (89)

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