RFS Advance Access originally published online on February 12, 2009
Review of Financial Studies 2009 22(11):4463-4492; doi:10.1093/rfs/hhp008
| ||||||||||||||||||||||||||||||||||||||||||||||||||
Expected Stock Returns and Variance Risk Premia
Duke University
Duke University
Federal Reserve Board
Send correspondence to Tim Bollerslev, Department of Economics, Duke University, Durham, NC 27708; telephone: 919-660-1846; fax: 919-684-8974. E-mail: boller{at}econ.duke.edu.
JEL Classification: C22, C51, C52, G12, G13, G14
 |
Abstract |
|---|
Motivated by the implications from a stylized self-contained general equilibrium model incorporating the effects of time-varying economic uncertainty, we show that the difference between implied and realized variation, or the variance risk premium, is able to explain a nontrivial fraction of the time-series variation in post-1990 aggregate stock market returns, with high (low) premia predicting high (low) future returns. Our empirical results depend crucially on the use of "model-free," as opposed to Black–Scholes, options implied volatilities, along with accurate realized variation measures constructed from high-frequency intraday as opposed to daily data. The magnitude of the predictability is particularly strong at the intermediate quarterly return horizon, where it dominates that afforded by other popular predictor variables, such as the P/E ratio, the default spread, and the consumption–wealth ratio.
Bollerslev's work was supported by a grant from the NSF to the NBER and CREATES funded by the Danish National Research Foundation. The paper combines results of an earlier paper with the same title by the first and the third authors, and a paper by the second author titled "Stochastic Volatility in General Equilibrium." Excellent research assistance was provided by Natalia Sizova. We would also like to thank an anonymous referee, John Ammer, Torben Andersen, Federico Bandi, Ravi Bansal, Oleg Bondarenko, Craig Burnside, Robert Hodrick, Pete Kyle, David Lando, Benoit Perron, Monika Piazzesi, Raman Uppal, Tuomo Vuolteenaho, Jonathan Wright, Amir Yaron, Motohiro Yogo, Alex Ziegler, and seminar participants at the Federal Reserve Board, the 2007 conference on "Return Predictability" at Copenhagen Business School, the 2007 SITE conference at Stanford, the 2007 NBER Summer Institute, the 2007 conference on "Measuring Dependence in Finance" at Cass Business School, and the 2008 Winter Meetings of the American Finance Association for helpful discussions. The views presented here are solely those of the authors and do not necessarily represent those of the Federal Reserve Board or its staff.