The VIX, the Variance Premium, and Expected Returns

Abstract

Existing studies find conflicting estimates of the risk-return relation. We show that the trade-off parameter is inconsistently estimated when observed or estimated conditional variances measure risk. The inconsistency arises from a misspecified, unbalanced, and endogenous return regression. These problems are eliminated if risk is captured by the variance premium instead. Yet, the variance premium is unobserved. Accordingly, 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 estimation methods, and reveals a significant link between the variance premium and economic uncertainty.

Download

The version of record can be downloaded here, while the accepted version can be freely downloaded here.

Recommended citation

Text

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://doi.org/10.1093/jjfinec/nby008

BibTex

@article{VERAVALDES2019,
    author = {Osterrieder, D. and Ventosa-Santaulària, D. and Vera-Valdés, J.E.},
    title = "{The VIX, the Variance Premium, and Expected Returns}",
    journal = {Journal of Financial Econometrics},
    volume = {17},
    number = {4},
    pages = {517-558},
    year = {2019},
    month = {04},
    issn = {1479-8409},
    doi = {10.1093/jjfinec/nby008},
    url = {https://doi.org/10.1093/jjfinec/nby008},
    }