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Dynamics of Variance Risk Premia, Investors' Sentiment and Return Predictability

Author

Listed:
  • Jeroen V.K. Rombouts

    (ESSEC Business School)

  • Lars Stentoft

    (University of Western Ontario and CREATES)

  • Francesco Violante

    (Aarhus University and CREATES)

Abstract

We develop a joint framework linking the physical variance and its risk neutral expectation implying variance risk premia that are persistent, appropriately reacting to changes in level and variability of the variance and naturally satisfying the sign constraint. Using option market data and realized variances, our model allows to infer the occurrence and size of extreme variance events, and construct indicators signalling agents sentiment towards future market conditions. Our results show that excess returns are to a large extent explained by fear or optimism towards future extreme variance events and only marginally by the premium associated with normal price fluctuations.

Suggested Citation

  • Jeroen V.K. Rombouts & Lars Stentoft & Francesco Violante, 2017. "Dynamics of Variance Risk Premia, Investors' Sentiment and Return Predictability," CREATES Research Papers 2017-10, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2017-10
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Variance risk premium; Return predictability; Sentiment indicators;
    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
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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