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Variance Premium, Downside Risk, and Expected Stock Returns

 

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Abstract

We decompose total variance into its bad and good components and measure the premia associated with their fluctuations using stock and option data from a large cross-section of firms. The total variance risk premium (VRP) represents the premium paid to insure against fluctuations in bad variance (called bad VRP), net of the premium received to compensate for fluctuations in good variance (called good VRP). Bad VRP provides a direct assessment of the degree to which asset downside risk may become extreme, while good VRP proxies for the degree to which asset upside potential may shrink. We find that bad VRP is important economically; in the cross-section, a one standard- deviation increase is associated with an increase of up to 13% in annualized expected excess returns.

Simultaneously going long on stocks with high bad VRP and short on stocks with low bad VRP yields an annualized risk adjusted expected excess return of 18%. This result remains significant in double-sort strategies and cross-sectional regressions controlling for a host of firm characteristics and exposures to regular and downside risk factors.

FEUNOU Bruno , Bank of Canada
LOPEZ ALLOUCHKIN Ricardo , Syracuse University
TEDONGAP Roméo , ESSEC Business School
XU Lai , Syracuse University

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Variance Premium, Downside Risk, and Expected Stock Returns
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