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Dynamics of Variance Risk Premia, Investors' Sentiment and Return Predictability

Jeroen V.K. Rombouts (), Lars Stentoft () and Francesco Violante ()
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Jeroen V.K. Rombouts: ESSEC Business School, Postal: Av. B. Hirsch, Cergy Pontoise, France 95021

CREATES Research Papers from Department of Economics and Business Economics, Aarhus University

Abstract: We develop a joint framework linking the physical variance and its risk neutral expectation implying variance risk premia that are persistent, appropriately reacting to changes in level and variability of the variance and naturally satisfying the sign constraint. Using option market data and realized variances, our model allows to infer the occurrence and size of extreme variance events, and construct indicators signalling agents sentiment towards future market conditions. Our results show that excess returns are to a large extent explained by fear or optimism towards future extreme variance events and only marginally by the premium associated with normal price fluctuations.

Keywords: Variance risk premium; Return predictability; Sentiment indicators (search for similar items in EconPapers)
JEL-codes: G12 G13 C58 (search for similar items in EconPapers)
Date: 0703
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