The VIX, the Variance Premium, and Expected Returns
Published in Journal of Financial Econometrics, 2018
Recommended citation: Osterrieder, D., Ventosa-Santaulària, D., and Vera-Valdés, J.E. (2019). "The VIX, the Variance Premium, and Expected Returns." Journal of Financial Econometrics. 17(4). https://vbn.aau.dk/da/publications/the-vix-the-variance-premium-and-expected-returns
We show that the risk-return trade-off parameter is inconsistently estimated when observed or estimated conditional variances measure risk. The inconsistency arises from misspecified, unbalanced, and endogenous return regressions. We propose a 2SLS estimator that produces consistent estimates without observing the variance premium. Using this method, we find a positive risk-return trade-off and long-run return predictability. Our approach outperforms commonly used risk-return estima- tion methods, and reveals a significant link between the VP and economic uncertainty.