Dynamic Relation between Volatility Risk Premia of Stock and Oil Returns

Volatility risk premium (VRP), defined as the difference between implied and realized volatilities, is found to have predictive power on the returns of many different assets (e.g., stocks, exchange rates, and commodities). While most of the extant research analyzes the return predictability of VRP, in this paper, we instead investigate the relation between the VRP of different assets, specifically stocks and oil. Using daily data of VRP from May 10, 2007 to May 16, 2017, we conduct VAR analyses on the stock and oil VRP and find that the effects of the stocks VRP on the oil VRP are limited and short-lived, if any. On the other hand, the VRP of oil has significantly positive and long-lasting effects on that of stocks after the outbreak of financial crises. These results suggest that the investors' sentiments (measured by VRP) are transmitted from the oil market to the stock market over time, but not the other way around, which is rather unexpected because financialization of commodities means a massive increase in investment in commodities by investors in traditional stock and bond markets, and hence the direction of effects is thought to be from the stock market to the commodity market.