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Variance swap payoffs, risk premia and extreme market conditions

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

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

Abstract: This paper estimates the Variance Risk Premium (VRP) directly from synthetic variance swap payoffs. Since variance swap payoffs are highly volatile, we extract the VRP by using signal extraction techniques based on a state-space representation of our model in combination with a simple economic constraint. Our approach, only requiring option implied volatilities and daily returns for the underlying, 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.

Keywords: Variance risk premium; Variance swaps; Return predictability; Factor Model; Kalman filter; CAPM (search for similar items in EconPapers)
JEL-codes: C12 C22 G12 G13 (search for similar items in EconPapers)
Date: 2017-05-30
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