The VIX, the Variance Premium, and Expected Returns

Daniela Osterrieder, Daniel Ventosa-Santaulària and J. Eduardo Vera-Valdés

The Journal of Financial Econometrics, 2019, vol. 17, issue 4, 517-558

Abstract: Existing studies find conflicting estimates of the risk–return relation. We show that the trade-off parameter is inconsistently estimated when observed or estimated conditional variances measure risk. The inconsistency arises from misspecified, unbalanced, and endogenous return regressions. These problems are eliminated if risk is captured by the variance premium (VP) instead; it is unobservable, however. We propose a 2SLS estimator that produces consistent estimates without observing the VP. Using this method, we find a positive risk–return trade-off and long-run return predictability. Our approach outperforms commonly used risk–return estimation methods, and reveals a significant link between the VP and economic uncertainty.

Keywords: fractional integration; implied variance; integrated variance; persistent predictor; return prediction; risk–return trade-off; variance premium (search for similar items in EconPapers)
JEL-codes: C22 C26 C51 G12 G13 (search for similar items in EconPapers)
Date: 2019
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