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A global factor in variance risk premia and local bond pricing

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  • Kaminska, Iryna

    (Bank of England)

  • Roberts-Sklar, Matt

    (Bank of England)

Abstract

In a world of interconnected financial markets it is plausible that risk appetite — an important factor in asset pricing — is determined globally. By constructing an estimate of variance risk premia (VRP) for UK, US and euro-area equity markets, we are able to estimate international variance risk premia and use them to construct a proxy for global risk aversion. The impact of this time-varying risk aversion proxy on bond risk premia is then analysed within an arbitrage-free term structure model of UK interest rates, where it is introduced explicitly as a pricing factor. By linking VRP to a stochastic discount factor, we find that the risk aversion factor has significantly affected UK government bond yields. The changes in the risk aversion factor have been particularly important in the period of the 2008–09 financial crisis, with medium maturity yields being affected the most.

Suggested Citation

  • Kaminska, Iryna & Roberts-Sklar, Matt, 2015. "A global factor in variance risk premia and local bond pricing," Bank of England working papers 576, Bank of England.
    • Handle: RePEc:boe:boeewp:0576
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    2. Wieladek, Tomasz & Haldane, Andrew & Roberts-Sklar, Matt & Young, Chris, 2016. "QE: the story so far," CEPR Discussion Papers 11691, C.E.P.R. Discussion Papers.
    3. Ana Aguilar & María Diego-Fernández & Rocio Elizondo & Jessica Roldán-Peña, 2022. "Term premium dynamics and its determinants: the Mexican case," BIS Working Papers 993, Bank for International Settlements.
    4. Mirco Rubin & Dario Ruzzi, 2020. "Equity tail risk in the treasury bond market," Temi di discussione (Economic working papers) 1311, Bank of Italy, Economic Research and International Relations Area.
    5. Aguilar-Argaez Ana María & Diego-Fernández Forseck María & Elizondo Rocío & Roldán-Peña Jessica, 2020. "Term Premium Dynamics and its Determinants: The Mexican Case," Working Papers 2020-18, Banco de México.
    6. Mirco Rubin & Dario Ruzzi, 2020. "Equity Tail Risk in the Treasury Bond Market," Papers 2007.05933, arXiv.org.
    7. Christos Ioannidis & Kook Ka, 2021. "Economic Policy Uncertainty and Bond Risk Premia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(6), pages 1479-1522, September.

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    More about this item

    Keywords

    Affine term structure models; option implied volatility; realized volatility; risk aversion; stochastic discount factor; variance risk premium; volatility forecasting;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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