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The Pricing of Tail Risk and the Equity Premium: Evidence from International Option Markets

Torben Andersen (), Nicola Fusari () and Viktor Todorov ()
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Nicola Fusari: The Johns Hopkins University Carey Business School, Postal: The Johns Hopkins University Carey Business School, Baltimore, MD 21202, USA
Viktor Todorov: Northwestern University, Postal: Kellogg School, Northwestern University, Evanston, IL 60208, USA

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

Abstract: We explore the pricing of tail risk as manifest in index options across international equity markets. The risk premium associated with negative tail events displays persistent shifts, unrelated to volatility. This tail risk premium is a potent predictor of future equity returns, while option-implied volatility only forecasts the future return variation. Hence, compensation for negative jump risk is the primary driver of the equity premium across all indices, whereas the reward for pure diffusive variance risk is largely unrelated to future equity returns. We also document pronounced commonalities, suggesting a high degree of integration among the major global equity markets.

Keywords: Equity Risk Premium; International Option Markets; Predictability; Tail Risk; Variance Risk Premium (search for similar items in EconPapers)
JEL-codes: G12 G13 G15 G17 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-rmg and nep-upt
Date: 2018-01-10
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