RFS Advance Access published online on May 6, 2009
Review of Financial Studies, doi:10.1093/rfs/hhp035
Variance Risk-Premium Dynamics: The Role of Jumps
Kellogg School of Management
Send correspondence to Viktor Todorov, Kellogg School of Management, 2001 Sheridan Road, Evanston, IL 60208; telephone: 847-467-0694. E-mail: v-todorov{at}kellogg.northwestern.edu.
JEL Classification: C51, C52, G12, G13
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Abstract |
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Using high-frequency stock market data and (synthetic) variance swap rates, this paper identifies and investigates the temporal variation in the market variance risk-premium. The variance risk is manifest in two salient features of financial returns: stochastic volatility and jumps. The pricing of these two components is analyzed in a general semiparametric framework. The key empirical results imply that investors' fears of future jumps are especially sensitive to recent jump activity and that their willingness to pay for protection against jumps increases significantly immediately after the occurrence of jumps. This in turn suggests that time-varying risk aversion, as previously documented in the literature, is primarily driven by large, or extreme, market moves. The dynamics of risk-neutral jump intensity extracted from deep out-of-the-money put options confirms these findings.
This paper is part of my PhD dissertation at the Department of Economics, Duke University. I would like to thank my advisors George Tauchen, Tim Bollerslev, Ron Gallant, and Han Hong for many discussions and encouragement. I would also like to thank the editor (Joel Hasbrouck) and anonymous referees for many helpful suggestions. I benefited also from comments, suggestions, and discussions with Yacine Ait-Sahalia, Torben Andersen, Ravi Bansal, Alan Bester, Nick Bloom, Mike Chernov, Javier Cicco, Gregory Connor, Darrell Duffie, Rob Engle, Stephen Figlewski, Joel Hasbrouck, Jean Jacod, Ravi Jagannathan, Robert Jarrow, Pedro Duarte, Paul Dudenhefer, Silvana Krasteva, Jonathan Mattingly, Ernesto Mordecki, Mark Podolskij, Barbara Rossi, Albert Shiryaev, Chris Sims, Ken Singleton, and Costis Skiadas; from seminar and conference participants at the Board of Governors, Carnegie-Mellon, Chicago GSB, Duke, Kellogg, LSE, NYU-Stern, Princeton, Stanford GSB; from the Conference on Stochastics in Science in Honor of Ole Barndorff-Nielsen, Guanajuato, Mexico, March 2006; and from the Financial Econometrics conference, Montreal, May 2007.