Variance risk premium and equity returns

Abstract

This study contributes to the age-old question of whether stock market returns are predictable by investigating the relationship of variance risk premium and equity returns. The volatilities derived from options prices typically exceed the corresponding subsequent realized volatilities of the underlying asset, suggesting that investors require additional compensation for bearing volatility risk. Therefore, an implied volatility index reflects not only the expected stock market uncertainty, but also investors’ risk aversion. This risk aversion element is part of investors’ compensation for bearing equity risk and can be measured by the variance risk premium. Our empirical findings show that the variance risk premium is on average negative for a range of stock market indices, stocks and exchange traded funds suggesting that market variance risk is indeed priced in. Finally, our results show that equity variance risk premium is a reliable predictor of equity returns, as it can explain up to 20% of the total variation in future equity returns at a monthly frequency. © 2018 Elsevier B.V.