- Aarhus University
mercoledì 6 luglio 2016
Polo Santa Marta, Via Cantarane 24, Room 1.59
This paper proposes a flexible approach for estimating the variance risk premium (VRP) which delivers more refined, precise and realistic estimates of the market price of risk. We define a class of structural time series models that isolates as structural components the dynamics of the physical variance and, by embedding its expectations into the model, the price attached by the market to the variance risk (i.e. the VRP). In fact, by doing this we deconstruct the mechanism of formation of the variance expectations under the risk neutral measure. Given the latent nature of the variables of interest of which only imprecise approximations are observable (i.e., high frequency return based variance measures and option implied risk neutral variance expectations), we advocate the use of methodologies based on signal extraction techniques. These techniques allow us to obtain measurement error free estimates of the VRP, and thus to disentangle, with a high degree of precision, its underlying time series properties as well as possible dependencies with the state of the economy. We advocate the inclusion of interactions and discontinuities, with emphasis on structural breaks, extreme events, uncertainty due to heteroskedasticity, correlations and spillovers, as being essential to replicate complex dynamics and interdependencies between the physical variance and its risk neutral expectation. In an empirical application to the SP500, we address the excess return puzzle by disentangling the predictability stemming from the part of the variance risk premium associated with normal sized price fluctuations from that associated with extreme events. We also construct several indicators of the investors’ attitude towards risk and agents’ sentiment which allow to determine which source of risk the agents’ effectively price. We also provide wide international evidence with respect to eight major markets. We find that excess returns are to a large extent explained by the agents’ perception and reaction to the type of extreme tail events (short tern vs. long lasting, positive vs. negative shock) and only marginally, if any at all, by the premium associated to normal price fluctuations.