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The VIX, the Variance Premium, and Expected Returns

Author

Listed:
  • Daniela Osterrieder
  • Daniel Ventosa-Santaulària
  • J Eduardo Vera-Valdés

Abstract

Existing studies find conflicting estimates of the risk–return relation. We show that the trade-off parameter is inconsistently estimated when observed or estimated conditional variances measure risk. The inconsistency arises from misspecified, unbalanced, and endogenous return regressions. These problems are eliminated if risk is captured by the variance premium (VP) instead; it is unobservable, however. We propose a 2SLS estimator that produces consistent estimates without observing the VP. Using this method, we find a positive risk–return trade-off and long-run return predictability. Our approach outperforms commonly used risk–return estimation methods, and reveals a significant link between the VP and economic uncertainty.

Suggested Citation

  • Daniela Osterrieder & Daniel Ventosa-Santaulària & J Eduardo Vera-Valdés, 2019. "The VIX, the Variance Premium, and Expected Returns," Journal of Financial Econometrics, Oxford University Press, vol. 17(4), pages 517-558.
    • Handle: RePEc:oup:jfinec:v:17:y:2019:i:4:p:517-558.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nby008
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    Citations

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    Cited by:

    1. J. Eduardo Vera-Valdés, 2021. "Nonfractional Long-Range Dependence: Long Memory, Antipersistence, and Aggregation," Econometrics, MDPI, vol. 9(4), pages 1-18, October.
    2. Andersen, Torben G. & Varneskov, Rasmus T., 2022. "Testing for parameter instability and structural change in persistent predictive regressions," Journal of Econometrics, Elsevier, vol. 231(2), pages 361-386.
    3. Ke-Li Xu & Junjie Guo, 2021. "A New Test for Multiple Predictive Regression," CAEPR Working Papers 2022-001 Classification-C, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    4. J. Eduardo Vera-Valdés, 2021. "Temperature Anomalies, Long Memory, and Aggregation," Econometrics, MDPI, vol. 9(1), pages 1-22, March.
    5. Vera-Valdés, J. Eduardo, 2022. "The persistence of financial volatility after COVID-19," Finance Research Letters, Elsevier, vol. 44(C).

    More about this item

    Keywords

    fractional integration; implied variance; integrated variance; persistent predictor; return prediction; risk–return trade-off; variance premium;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C26 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Instrumental Variables (IV) Estimation
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation

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