Working Paper

Variance risk premia, asset predictability puzzles, and macroeconomic uncertainty

Abstract: This paper presents predictability evidence from the difference between implied and expected variances or variance risk premium that: (1) the variance difference measure predicts a significant positive risk premium across equity, bond, and credit markets; (2) the predictability is short-run, in that it peaks around one to four months and dies out as the horizon increases; and (3) such a short-run predictability is complementary to that of the standard predictor variables--P/E ratio, forward spread, and short rate. These findings are potentially justifiable by a general equilibrium model with recursive preference that incorporates stochastic economic uncertainty. Calibration evidence suggests that such a framework is capable of reproducing the variance premium dynamics, especially its high skewness and kurtosis, without introducing jumps. The calibrated model can also qualitatively explain the equity premium puzzle and the bond risk premia in short horizons.

Keywords: Risk management; Rate of return;

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2010

Number: 2010-14