The VIX, the Variance Premium, and Expected Returns

Long Memory

D. Osterrieder

D. Ventosa-Santaulària

J.E. Vera-Valdés




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.


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